LIBOR: London InterBank Offered Rates

by Anisha Bhardwaj


Recently terms like LIBOR and Barclays have been making the headlines. Though it may not seem to be of direct relevance to you, you’ll be surprised at how consequential it can be. Once again the global economy is highly integrated and a glitch in one part most definitely has an impact on every player in the economy. So what is all the jargon about?

Barclay's is a major global financial services provider engaged in personal banking, credit cards, corporate and investment banking and wealth and investment management with an extensive international presence in Europe, the Americas, Africa and Asia. Its acquisition of Lehman Brother’s after they filed for bankruptcy was a major highlight after the 2008 crises. Surprisingly then it was more than shocking to hear it being involved majorly in the LIBOR fixing scandal.

In June 2012, through intensive international investigation by the Financial Services Authority (FSA) which is a regulator of all providers of financial services in the UK, its involvement in the manipulation of LIBOR came to fore and left millions of customers affected and also resulted in Barclays paying a hefty fine of US$ 450 million.

Banks borrow money from each other for the purpose of lending to customers if they are falling short of their required cash reserves determined by the central bank of the country in which the banks operate in. Thus, it’s natural for a few banks to be in excess of such reserves and they lend it to others for a certain specified interest. The London Interbank Offered Rate (LIBOR) is the average interest rate estimated by leading banks in London that they would charge for borrowings from each other. It is the primary benchmark, along with the EurIBOR (European Interbank Offered Rate), for short term interest rates around the world. It is calculated by Thomas Reuters (world's leading source of intelligent information for businesses and professionals) as a service for the British Bankers Association (BBA – a leading trade association for the UK banking and financial services sector).

The LIBOR provides a benchmark for various types of securities and financial transactions including mortgages, credit card rates, investment returns in commodities. Securities are nothing but mere documents representing an interest or a right in something else; they are not consumed or used in the same way as traditional consumer goods. Similarly a Mortgage is the charging of real (or personal) property by a debtor to a creditor as security for a debt.

Several people also invest in commodity markets (a market where raw or primary products such as oil, silver and gold are traded). With the advancement we’ve been witnessing, a lot of consumption is derived by paying through credit cards which often have a high amount of interest payments to be paid at a certain pre decided later date. All these economic activities are fundamentally linked to the LIBOR rates and get directly affected through its manipulation.

The Problem

LIBOR isn’t set by supply and demand. It’s not set by the market or the government. Instead, it depends on the banks involved (including giants like Citigroup, JP Morgan Chase, Bank of America, and Barclays) to accurately report the interest rates they’d have to pay to borrow from each other. The highest and lowest rates are thrown out, the rest are averaged, and LIBOR is set. So LIBOR depends on honesty. If banks don’t tell the truth, LIBOR won’t be accurate – nor will the interest rates on trillions of dollars worth of loans and investments.

Calculation

Once a day, major London banks tell Thomson Reuters the interest rate they would expect to pay on a loan from another bank. Thomson Reuters drops those rates in the highest and lowest 25% and averages the 50% in the middle. There are actually 150 Libor rates, with maturities (the length of time until an investment returns its original investment at the date mentioned above) from overnight to one year, and in different currencies.

Lying about LIBOR

Banks would lie about the rates they’d pay to borrow for two reasons: the first is to make themselves seem stronger than they are. As with you and me, if a bank has good credit standing they’ll pay less interest. So if a bank reports that the rate it pays to borrow from other banks is low, the financial world will think they’re strong signalling a misleading health of the financial system.

The other reason a bank may want to lie about what it costs them to borrow is to make money. Major international banks do more than lend. They also trade stocks, bonds, and all kinds of other investments for the same reason any investor does: to make a profit.

Traders working for banks participating in LIBOR could simply buy an investment that goes up when rates fall, then lie about their rates in an attempt to lower LIBOR. In short, they could manipulate the market and position their investments to make money, essentially trading on inside information. This is especially true if banks magnified the impact of their reporting by colluding with one another. It did so that its traders could make profits on derivatives (contracts made by two parties stating conditions under which the payment is to be made) pegged to the base rate. Derivative traders often asked the Barclay's employees who submitted the rates to provide figures that would benefit the traders, instead of submitting the rates the bank would actually pay to borrow money.

Effects

Since LIBOR is the benchmark for many other rates, an inaccurate LIBOR means millions of people all over the globe might have paid more or less interest than they should have. If rates were artificially low, borrowers for things like adjustable-rate mortgages and student loans would have benefited as when the rate was pushed down their cumulative payments fell. But investors like mutual funds and pension plans may have earned less than they should have as their yield depended on market existing LIBOR which was consistently lowered by banks since 2005. It is estimated that only 2% of mortgages currently being repaid will have a direct link to Libor, and those would have typically been sub-prime, buy- to-let or from a private bank. It could be argued that the Libor-rigging affected retail banks' own funding costs and thereby indirectly had an impact on the pricing of their mortgages and loans. Savers with money in ordinary savings accounts with banks and building society shouldn't worry that rates have been depressed by Libor rate-rigging. The interest paid on deposits are linked to the Bank of England base rate, not Libor.