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Posted in Finance Articles, Total Reads: 2059 , Published on August 30, 2012

“There is no doubt in my mind that what we saw, what peaked in 2008, was rotten to the core,” said British deputy prime minister Nick Clegg about the banking system. And the fact of the matter is ,under the current circumstances, many would not dispute the statement. The banking system that has been under attack post the 2008 crisis is now facing another major scandal, the bank under question Barclays ,one of the oldest banks in England. So what did they do?.Well they manipulated the interest rates called LIBOR (London Interbank Offered Rate) the benchmark rates for financial instruments worldwide, affecting trillions of dollars of derivatives and mortgages.

Barclays has been fined 450 million dollars and  Bob Diamond ,the CEO of the bank has resigned and more heads are set to roll. The issue is not restricted to just Barclays and other banks like UBS, Royal Bank of Scotland are all facing investigations by the Financial Services Authority(FSA) on suspected collusion to fix these rates. So what are these rates and why are they so important?

LIBOR in simple terms is the average interest rate at which banks lend to each other. It is considered to be the primary benchmark rate along with EURIBOR for short term interest rates around the world. Many financial institutions base their lending rate on the basis of these rates by quoting LIBOR sometimes with a spread. At least 350 trillion dollars worth of derivatives and  10 trillion dollars worth mortgages depend on these rates. Thus these rates become an extremely important infrastructure of the financial system, but like plumbing it doesn’t get noticed.

Calculation of Libor rates

Libor is defined as “The rate at which an individual Contributor Panel bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to 11.00 London time.”

A group of contributor banks are selected by a panel based on their scale of market activity, credit rating and expertise in the currency concerned. The cash desk at these banks submit the interest rates on their Reuter screens before 11:am everyday .A simple computer program would then use an algorithm to weed out the outliers (the top 4 and the bottom 4 interest rates ) and the arithmetical average of the eight is found and this is the final LIBOR rate

Looking carefully at the definition, the submitted rate is the rate at which contributor panel bank Could borrow funds and not at which they have actually borrowed funds. The reason that the measurement is not based on actual transactions is because LIBOR has to be quoted for 15 maturities and 16 currencies and not every bank borrows substantial amounts for each maturity every day .So the rate submission has a lot of judgement involved, which implies there is subjectivity. Thus there is obviously the risk for manipulation.

This is why all the outliers are weeded out from the set and another. Another way this risk of manipulation is mitigated is that the rates quoted by each bank is published and will be under a lot of scrutiny ,especially by the brokers. Any misconduct ,if caught would lead to severe disrepute and possible exclusion from the contributor panel. All these measures should have made sure that no manipulation happened ,but it is to be noted that none of these measures actually took into consideration, the possibility of a cartel being formed,and eventually this was what happened.

The Controversy

Bloomberg: “We used to say during the financial crisis a few years ago that interbank rates are rates at which banks won’t lend to each other, and sadly that’s still the case today – Richard McGuire, a senior fixed-income strategist at Rabobank(December 2011)

This is not the first time that LIBOR has come under suspicion. In 2008,Wall Street journal study indicated that many banks including Citigroup, JP Morgan and UBS had reported significantly lower interest rates in their LIBOR submissions. The study compared the rates from the default insurance markets (these rates usually move in tandem with the LIBOR ) and found that there were significant variations. Following the report the contributor panel was increased to include 16 banks.

UBS became the first bank to publicly report in 2011 that investigations were underway regarding their LIBOR submissions. So the Barclays rate rigging does not really come across as a shocker for people in the financial world. So why did Barclays rig these interest rates? There were two reasons behind the rate rigging:

1 .A good reason to manipulate the interest rate would be to inflate the profits of the trading desk of the bank as the trading books of the bank would be exposed to huge amounts in derivatives which depend on these rates. In the system, ideally there should be a wall between the trading desk and the LIBOR submission team. But in the case of Barclays banks, let alone the non-existence of the wall, even an effort to make the communication discrete was absent. In fact  the email evidence that came out of the investigations prove that both parties thought it “normal” to manipulate and cheat the financial markets.

“Coffees will be coming your way,” promised one trader in exchange for a fiddled number. “Dude. I owe you big time!… I’m opening a bottle of Bollinger,” wrote another trader

Even though the senior management has washed their hands off this, putting the blame on a few “errant “ traders, it is hard to understand how these traders in the lower management could indulge in such situation without the knowledge of the top management.

2. The second reason why Barclays bank indulged in rigging was to project healthy financial condition of the bank.The bank quoted lower rates than what they were actually quoting in the market to ensure that investors and depositors are not concerned and to possibly prevent a bank run. This happened during the credit crunch of 2008.This was done with the full consent of the top management, with the silent nod of the bank of England as Bob Diamond claims ,even though Mervyn King, BOE Governor vehemently denied the allegation.

Conflict of interest is apparent and it is obvious that an alternative to LIBOR needs to be found , but unfortunately there are few alternatives around based on actual transactions.Some of the alternatives are to use the overnight rates or the repo rates (both the markets are pretty active),but there is the limitation that market activity  is for a limited number of maturities.

This extremely serious scandal of global proportions would adversely affect the already hurt financial markets and would accelerate the onset of more regulations in the banking industry. It is indeed sad that the Gordon Gekkos of this world never learn.

This article has been authored by Ullas Mohan from NMIMS.

Image: FreeDigitalPhotos.net

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