Libor, or when all banks lied

Along with the many questions about Barclays that remain (from how much senior management knew to potential interference by government officials), one of the big issues that must be dealt with is where we go from here with the inter-bank borrowing rate at the heart of it all — the rate that serves as a benchmark for the pricing of trillions of dollars of assets globally.

The London Interbank Offered Rate dates back to the development of the inter bank lending market in the 1960s.

“The interbank market was a more efficient way for banks to offset payment imbalances — shortages and surpluses of currency — over the short term than official channels,” says Dr Angus Armstrong, director of macroeconomic research at the National Institute for Economic and Social Research in London.

How it started

In its current guise Libor came about in the wake of the burgeoning market for interest rate swaps, foreign currency options and other instruments banks began to trade actively in the 1980s.

At the time London was attempting to build up its status as a global financial centre — something that speeded up rapidly following the “big bang” de-regulatory reforms of the government of Margaret Thatcher in 1986.

“While recognising that such instruments brought more business and greater depth to the London interbank market, it was felt that future growth could be inhibited unless a measure of uniformity was introduced,” the British Bankers Association, which set up Libor in 1986, explains in a briefing note.

Over the years, Libor’s status as a benchmark rate grew rapidly — covering vast asset classes, including consumer loans, in a move that thrilled observers who believed it would help bring new competition into the market.

Financiers across the world were “much more likely to invest in American home mortgages if the rates on those loans were tied to Libor, rather than to measures they’ve never heard of,” wrote a Washington Post columnist in 1988. While some queried how long Libor’s status as the benchmark would last, over time, its grip only grew stronger.

Some $350 trillion of derivative contracts and $10 trillion of loans are now indexed to Libor globally, it is estimated.

“Judging by the amount of money directly dependent on it, the British Bankers Association’s Libor matters more than any other set of numbers in the world,” wrote Edinburgh University professor Donald MacKenzie in the London Review of Books in 2008.

Investors valued the degree of standardisation Libor offered, being based on the rate at which a bank “could borrow funds, were it to do so by asking for and then accepting inter bank offers in a reasonable market size just prior to 11 a.m. London time” and calculated in the same way across 10 currencies and 15 different maturity periods from overnight to 12 months.

Under-scrutinised

In the interests of transparency, not just the Libor “fixing” as the average has come to be known, but the individual submissions by the banks on each contributor panel are published.

And to avoid anomalies, the lower and upper quartile of submissions are each eliminated before the average is taken. The whole process is overseen by the British Bankers Association, the trade association representing some 200 banks from across the world, which also sets the calculation process for the rates.

Quite how under-scrutinised these crucial numbers have been has become very apparent in the last few weeks.

Britain’s Financial Services Authority — which alongside the US Department of Justice and US Commodities Future Trading Commission — fined Barclays a total of Rs 2,500 crore — has admitted it didn’t have the power to bring criminal charges against banks on the grounds of Libor manipulation.

Britain’s Serious Fraud Office this week said it was launching a criminal investigation, while the FSA is reviewing its powers, but it’s still hard to understand how such a crucial part of the financial system could have been so overlooked, and left in the hands of the BBA.

Spotlight on anomalies

Dr Armstrong argues the attitude to Libor was part of a wider problem with the regulatory approach, which treated banks as isolated institutions without taking into consideration the conditions that made them thrive.

“The oxygen they live in is the market they trade in and use for funding,” he argues. “But the regulators didn’t think about the quality of the air the banks existed in.”

In fact, there seemed to be scant public questioning of Libor at all until a Wall Street Journal investigation in 2008 pointed to anomalies in submitted rates and questioned whether banks were understating their borrowing costs to avoid rumours about financial soundness.

A flurry of research followed, suggesting that rates manipulation was not just happening at the height of the post-Lehman crisis, when one may have expected banks to be the most wary.

A 2010 study by academics at UCLA and the University of Minnesota found that misreporting was stronger in the period after the markets calmed down, and that incentives for misreporting (both for the banks’ reputation as well as for traders’ own positions linked to Libor) remained throughout.

What is now clear is that that transparency failed to prevent misreporting, while simply eliminating the upper and lower quartile figures is of limited help if the manipulation is widespread. And widespread it was: there are some 20 banks under investigation.

Reform imperative

Yet doing away with Libor is far from being the obvious solution that it may seem — as would a switch to reporting actual rather than notional figures by the banks. Libor’s attraction partly lies in the huge range of 150 different rates it is able to offer across maturities and currencies, precisely because it is notional.

With demand for longer maturities in particular being thin, and lending without collateral a struggle, it could be hard to offer quite the range that Libor does in its current guise, or capture conditions in the market as it has managed to.

There are, of course, an increasing number of alternatives — such as “Ronia,” launched by Britain’s Wholesale Market Brokers’ Association based on overnight funding rates in sterling, or the GCF Repo Index in the US.

However, the problems of extracting the trillions worth of existing contracts from their Libor-link will prove an additional challenge to their rise.

Which leaves us with the issue of Libor reform: the Commodity Futures Trading Commission’s Order against Barclays provides an inkling of some of the reforms that regulators will seek.

The bank has been ordered to work with the BBA and regulators on a six-point plan to improve the system, including better methodology for formulating submissions, a stronger verification and monitoring system, periodic examination of whether the benchmark rate accurately reflects the rate at which actual transactions are happening, and far greater scrutiny by the regulators themselves.

Of course, these steps don’t tackle some of the most unsavoury aspects of the scandal, particularly the culture that fostered a world where traders nudged others to misreport deeply impactful figures with promises of “Bollinger” or having their name “written in gold letters” — telling details that have emerged in the reports of regulators, which show how much more reform is needed.

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