LIBOR’s Labour’s Lost

Posted in Finance Articles, Total Reads: 2317 , Published on 30 October 2012
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In 1598, William Shakespeare scripted the rib-tickling comedy “Love’s Labour’s Lost”. The world has seen an unprecedented paradigm shift by then. But, now, the history seems to repeat itself. This time around, Barclays comes up with an ad nauseam thriller, “LIBOR’s Labour’s Lost”.

Prelude

During the late 1984 and early 1985, the financial world felt an inalienable need to provide a standardized rate to facilitate the ever increasing usage of new financial instruments such as interest rate swaps, foreign currency options, and forward rate agreements, that’s when LIBOR, or the London Interbank Offered Rate, was born. Countries that rely on the LIBOR for a reference rate include the likes of United States, Canada, Switzerland and the U.K.

LIBOR is the average interest rate estimated by leading banks in London. The Banks charge this rate for lending credit to other banks in the London Interbank Market. For instance, a multi-national corporation (MNC) with a very good credit rating may be able to borrow money for one year at LIBOR plus four to five points. LIBOR is calculated and published by Thomson Reuters on behalf of the British Banker’s Association (BBA) after 11:00 AM (usually around 11:45 AM) each day (London time) on a daily basis wherein they survey interbank interest rate quotes by 16 large banks. The submitted rates are, then, ranked and the mean is calculated using only the two middle quartiles of the ranking. So, if 16 rates are submitted, the middle 8 rates are used to calculate the mean. The calculated mean becomes the London Inter-bank Offered Rate for that particular currency, maturity, and fixing date. The rate at which each bank submits must be formed from that bank’s perception of its cost of funds in the interbank market. It is published for various currencies and for maturities ranging from overnight to one year.

BBA follows a typical, believed by many as immaculate, method for calculating the sacrosanct LIBOR for the day. LIBOR plays a much crucial role by not only providing information about the cost of borrowing in different currencies but it also actually influences it. LIBOR, the lingua franca of the banks helps them in figuring out what they should charge for not just home loans, but car loans, commercial loans, credit cards.

Plot (LIBOR… Lie More?)

So far the LIBOR’s journey was a dream run. Right from its inception, it has enjoyed fame and acceptance in a world where change is the only constant. But, all was not rosy as it appeared. As every flick has its protagonist, this story had the Wall Street Journal (WSJ) as its saviour. In 2008, WSJ released a controversial study suggesting that some banks might have understated borrowing costs they reported for LIBOR during the 2008 credit crunch that may have misled others about the financial position of these banks.

To obliterate gloomy economic scenario, banks showed lower than actual interest rates. The lower interest rates therefore resulted in lower LIBOR and thus heaved up the confidence and increased lending. As LIBOR is the average of the interest quotes by different banks, so rigging of LIBOR would have involved many banks.

Why was the rate rigged in the first place? A close examination into the issue transpired that Barclays was itself facing rising interest rates; had it provided the same rates to BBA, it would have created an unhealthy picture on the bank’s financial stability and liquidity issues it was facing would have surfaced. So, in order to protect its own interest Barclays resented on reporting (read rigging) lower rates so as to present a merrier outlook to the outer world. The rigging happened between 2005 and 2009, as often as daily.

Creating a bang in the already turbulent banking world- thanks to Euro crisis, the WSJ report on rigging was welcomed with raised eyebrows and harsh criticisms. A fast-paced turns of events ranging from staunch investigations into the conversations of Barclays’ CEO Bob Diamond and the Deputy Governor of Bank of England to the Barclays’ public admittance of the rigging, the world witnessed abdication of three stalwarts of Barclays from the throne. Barclays Bank was fined a total of £290 million (US$450 million) for attempting to manipulate the daily settings of LIBOR.

What’s the big deal?

Upshots on proletarian: If LIBOR is very high that means one needs to dish out more to avail the credit. If it’s maneuvered towards a lower rate, it implies that your interest earnings on savings account would be subdued. Hence, in either ways, a manipulation would lead to common man’s loss.

As it is used as a benchmark for deciding various rates across numerous banks including central banks or even EURIBOR, so at a macroeconomic scale, it has the potential to create many ripples in financial assets worth $500 trillion.

Mumbai Inter-Bank Offered Rate (MIBOR) - The Younger Brother

In India, as the financial markets started developing, the need for a reference rate in the debt market was felt. The National Stock Exchange (NSE) on 15 June 1998, developed the Mumbai Inter-Bank Offered Rate, referred to as MIBOR, on the lines of LIBOR.

These rates are calculated by a combination of two methods—polling and bootstrapping. In the polling method, like in the case of LIBOR, the data is collected from the panel of 30 banks which has a mix of public sector banks, private sector banks, foreign banks and primary dealers.

How safe is MIBOR?

As MIBOR shares a similar DNA as that of its elder brother LIBOR, it might also have a little room to get manipulated.

But, MIBOR has its own merits over LIBOR which makes it a bit safer. Firstly, instead of omitting 2 highest and 2 lowest rates as is done in case of LIBOR, NSE uses a statistical technique called bootstrapping to separate the outliers and determine the mean rate. It is expected to help against any attempt by the market participants to come together and influence rates. Secondly, though in a less extent, the very fact of Indian banking system being largely dominated by public sector banks makes one to believe that MIBOR could not be affected by private players to satiate their own interests.

Learning from LIBOR scandal

Prior to the exposure of scandal, proponents of LIBOR were too confident about its piousness. Promoters of MIBOR such as Reserve Bank of India (RBI) should act proactively to tighten the possible loose links and to cover the undiscovered loopholes.

The case in point is the possible switching over of MIBOR calculation to actual dealt rates on a trading platform. As India has online, screen-based trading of money market instruments such as call money, unlike voice-based markets in many countries, it makes sense to move to a transparent, actual screen based traded rate system which could capture actual MIBOR levels.

Epilogue

As the Shakespeare’s classic had not only the King of Navarre involved in the promiscuity, he had an unflinching support from his three noble companions as well, on a similar line, even in this story Barclays is not forlorn, they reportedly, have support from many other players (refer to Exhibit 1) of the game. The immediate action in the current context should be to identify the hidden miscreants and subject them to serious punishments.

What we require today from regulators is not merely whipping fines on the perpetrators rather a system should evolve wherein there is no scope for manipulation at all.

The world is now hopeful that one day, preferably sooner than later, the system should get clear of all the malpractices and the market participants can again reinforce their faith in LIBOR.

The time must come sooner when we could say, “LIBOR’s LABOUR’s WON!”

This article has been authored by Prakash Nishtala & Anuj Narula from NMIMS.

Image: FreeDigitalPhotos.net


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