Behind the LIBOR Scandal

What is LIBOR and Why Does it Matter?

Behind the LIBOR Scandal
May 26, 2015

The London Interbank Offered Rate, known as LIBOR, is the primary interest rate benchmark for worldwide financial markets. It's used as a reference point and adjustment mechanism in everything from adjustable rate mortgages to derivatives, futures, and options. LIBOR rates are published every day — 35 different rates covering 5 currencies and 7 maturities. They are closely watched, as small changes in the LIBOR rates can have massive ripple effects throughout the financial world.

Where do the rates come from? They are calculated from estimates provided by over a dozen of the largest banks on the short-term interest they would pay to borrow money from other banks. Originally, the British Banker's Association (BBA) performed the calculations, throwing out high and low estimates and averaging the rest according to a set formula.

With that sort of smoothing, theoretically no one bank can manipulate their rates to throw off the market. That may be true, but banks can still manipulate their reported rate for their own gain — and have been doing so for some time.

The issue came to the attention of regulators in mid-2008 after an official at Barclay's told officials at the Fed that Barclay's did not always post "an honest rate" and that other banks were also misrepresenting rates — thus Barclay's was "fitting in with the rest of the crowd." Thus began a prolonged investigation, which has been producing fines and other regulatory actions since 2012.

Why manipulate the LIBOR rate? There are two general reasons:

  • Misrepresentation – Some banks misrepresented their overall financial health by underreporting their lending rate. Even though LIBOR submissions are estimates, some of the underreporting was painfully obvious. Citigroup was one of the worst according to a study mentioned in Fortune, reporting lending rates on an average of 42% lower than the actual rate between mid-2007 and mid-2010.

    However, Citi recently reported that the Justice Department has dropped its investigation and that criminal charges will not be filed, although $80 million has already been paid to European regulators and further civil penalties may be pending in the US. Regulators appear to have concluded that Citi was mostly trying to boost its appearance of financial health, instead of indulging in the second reason below.

  • Rate-Rigging for Traders – Various banks had been manipulating the LIBOR rate at the request of traders in order to make money on derivatives and other financial vehicles. In some cases, there was a quid pro quo connection verified through e-mail communications.

    Some e-mails uncovered from traders were almost juvenile in their literal begging of the banks to manipulate the rates. Others were quite direct, including one from a UBS trader that promised to "pay whatever you want" in return for rate manipulation.

Most of the banks have received large fines from both European and American regulators focusing on the rate-rigging aspect. Barclay's settled for $450 million, while UBS settled for $1.5 billion. Other fines included $612 million for RBS, $87 million for ICAP, $1 billion for Dutch Rabobank and $380 million for Lloyd's. European regulators doled out $2.3 billion in fines among eight banks in December 2013 and another $120 million over four banks in October 2014.

However, the strongest punishment on an individual bank was recently levied against Deutsche Bank — $2.5 billion in fines and a guilty plea from their UK subsidiary for wire fraud. The US component of the investigation has also included a cease-and-desist order regarding violations of the Commodity Exchange Act.

Previous plea agreements have been revisited as the US takes a more aggressive stance. According to the Financial Times, the Justice Department had been threatening to scrap a previous non-prosecution agreement with UBS thanks to a potentially expanding fraud investigation. They followed through on that threat on May 20th by allowing UBS to plead guilty on the LIBOR manipulation charge in exchange for immunity in a larger case — criminal conspiracy charges of price manipulation against Barclays, Citigroup, JPMorgan Chase, and RBS and a combined $5.6 billion fine.

While some changes have been made to the LIBOR process, there is no true guarantee that the same sort of abuse cannot happen again. ICE Benchmark Administration (IBA) now calculates the rate, but it is still dependent on polls. Discussions have taken place about using different methods than polling to set the LIBOR rate, but given the typical regulatory pace and the tremendous temptations posed by rate manipulations, don't expect banks to give up much control anytime soon — even with criminal charges and whopping fines related to past behavior.


Photo ©iStock.com/joxxxxjo

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