The LIBOR scandal infects Global Financial Markets

Last week it was disclosed that Barclays, a 300-year-old British bank, rigged the LIBOR rate. The LIBOR is a borrowing rate set daily by a panel of banks for ten currencies and for 15 maturities. The most important of these, three-month dollar LIBOR, is supposed to indicate what a bank would pay to borrow dollars for three months from other banks at 11am on the day it is set. The dollar rate is fixed each day by taking estimates from a panel, currently comprising 18 banks, of what they think they would have to pay to borrow if they needed money. The top four and bottom four estimates are then discarded, and LIBOR is the average of those left. The submissions of all the participants are published, along with each day’s LIBOR fix.

Many financial institutions, mortgage lenders and credit card agencies set their own rates relative to (and typically higher than) LIBOR. The LIBOR is among the most common of benchmark interest rate indexes used to make adjustments to adjustable rate mortgages. So, it affects virtually all people around the world and the scandal described below threatens to infect the global financial system if left unchecked.

Over the past week strong evidence has emerged in documents detailing a settlement between Barclays and regulators in the U.S. and Britain that employees at the bank and at several other unnamed banks tried to rig the number time and again over a period of at least five years. Investigations by regulators in several countries, including Canada, America, Japan, the EU, Switzerland and Britain, are looking into allegations that LIBOR and similar rates were rigged by large numbers of banks. Corporations and lawyers, too, are examining whether they can sue Barclays or other banks for harm they have suffered. That could cost the banking industry tens of billions of dollars.

As many as 20 big banks have been named in various investigations or lawsuits alleging that LIBOR was rigged. The scandal also corrodes further what little remains of public trust in banks and those who run them. Still, the fraud is bigger than just LIBOR manipulation.

A second sort of LIBOR-rigging has also emerged in the Barclays settlement. Barclays and, apparently, many other banks submitted dishonestly low estimates of bank borrowing costs over at least two years, including during the depths of the financial crisis. In terms of the scale of manipulation, this appears to have been far more egregious—at least in terms of the numbers. Almost all the banks in the LIBOR panels were submitting rates that may have been 30-40 basis points too low on average. That could create the biggest liabilities for the banks involved.

As the financial crisis began in the middle of 2007, credit markets for banks started to freeze up. Banks began to suffer losses on their holdings of toxic securities relating to American subprime mortgages. With unexploded bombs littering the banking system, banks were reluctant to lend to one another, leading to shortages of funding system-wide. This only intensified in late 2007 when Northern Rock, a British mortgage lender, experienced a bank run that started in the money markets. It soon had to be taken over by the state. In these febrile market conditions, with almost no interbank lending taking place, there were little real data to use as a basis when submitting LIBOR. Barclays maintains that it tried to post honest assessments in its LIBOR submissions, but found that it was constantly above the submissions of rival banks, including some that were unmistakably weaker.

At the time, questions were asked about the financial health of Barclays because its LIBOR submissions were higher. Back then, Barclays insiders said they were posting numbers that were honest while others were fiddling theirs, citing examples of banks that were trying to get funding in money markets at rates that were 30 basis points higher than those they were submitting for LIBOR.

Regulators around the world are concerned that global financial markets may have been rigged by a large number of banks. The list of institutions that have said they are either co-operating with investigations or being questioned includes many of the world’s biggest banks. Among those that have disclosed their involvement are Citigroup, Deutsche Bank, HSBC, JPMorgan Chase, RBS and UBS.

The U.K. Serious Fraud Office (SFO) opened a criminal probe into the attempted rigging of interest rates that led to a record fine against Barclays, adding to pressure on banks already under investigation by regulators around the globe. (As a side point, I never could understand why, in certain countries, large scale frauds ware distinguished from tamer ones by having the “Serious Frauds Office” do the investigation. It seems to me all frauds are serious on their face.)

Politicians including Chancellor of the Exchequer George Osborne and Opposition Labour leader Ed Miliband called for a criminal probe after Britain’s second-biggest bank was fined $451 million two weeks ago in the UK and U.S. for submitting false LIBOR rates. Chief Executive Officer Robert Diamond and Chief Operating Officer Jerry Del Missier resigned over the scandal.

The SFO joins the U.S. Department of Justice in criminally investigating how derivatives traders and rate submitters colluded to rig interbank offered rates. The U.K. Financial Services Authority is seeking civil penalties against banks and has said its criminal powers don’t include Libor rigging.

As part of the U.S. and U.K. settlements, Barclays admitted rigging the LIBOR as well as Euribor, its equivalent in euros, as early as 2005. In testimony to the British Parliament last week, Diamond apologized and said 14 Barclays traders were involved.

Citigroup Inc., Royal Bank of Scotland Group Plc, UBS AG, ICAP Plc, Lloyds Banking Group Plc and Deutsche Bank AG are among the firms regulators are investigating. About 18 banks are surveyed as part of the process of determining LIBOR rates.

The bottom line is now global interest rates and the global financial system is coming under attack. If we can’t trust that system, then the global transfer of money may be in doubt. In the US, we have our own problems with the financial system. Now, we have to consider the LIBOR-rigged rate problem to determine how, and to what extent, it has affected the actions and performance of US banks. US regulatory authorities should investigate as quickly as possible to assure investors the scandal has been controlled.

Blog posted by Steven Mintz, aka Ethics Sage, on July 14, 2012