Libor under the lash

7th March 2012

It's Libor, the interest level that stands behind many mortgage rates and unsecured loans as well as providing the essential numbers for trillions of dollars of more complex products. But while Libor is an essential part of the financial scene, only a minority have any idea what it means, fewer could hazard a guess at the rate, and just a handful know that this vital capitalism component is privately owned and not subject to any external regulation.

And this lack of oversight is now under fire as its users and rate setters – they're the same as banks both rely on Libor and establish its level on a daily basis – stand accused of manipulating the figures for their own profit. The UK watchdog the Financial Services Authority has one investigation in train, the Canadians are looking into seven major banks to see if they conspired to set rates for their own benefit, and US authorities including the Department of Justice are probing a number of big Wall Street names.

What is Libor?

Libor is the London Interbank Offered Rate, the level at which banks are prepared to lend to each other. It is available in 15 maturities (ranging from overnight via one day, one week and for numbers of months to 12 months) and in 10 different currencies (including the dollar, pound, and Swiss franc). You can find rates on the Global Rates website. Many Asian currencies are covered by Tibor – the Tokyo equivalent – while the euro relies on euribor. But the London rate is the most important.

Libor is set each working day at 11:45 a.m. (London time) by the British Bankers' Association (BBA).a privately owned group which lobbies for the banks and which has no statutory basis. The BBA libor website shows all the rates but only up to two months in arrears.  

It's an essential component because it is a benchmark for all sorts of financial products including savings accounts and home loans. Changes can affect everyone from major banks to consumers.

How is it calculated?

Each currency has a number of banks – usually around 16 to 20 – which provide information daily on the level at which they will lend to fellow banks. This is sent to the BBA although the calculation comes from Thompson Reuters. For each maturity and currency, the BBA lists all the rates supplied in descending order. The top four and the bottom four are removed; those remaining are averaged (known as a trimmed mean) to give the figures.

Having some idea of the rate before it is announced or knowing the direction in which it will move can give participants advantages. Even a fraction of a basis point (0.01%) can make or break fortunes in this market on which some $350 trillion in interest rate swaps depends as well as $10 trillion of bonds and loans.

It does not represent actual interbank lending but, as FTI Consulting points out, the rate at which banks "could" borrow funds. So there is no connection to actual trading.

The alleged manipulation takes a number of forms. One way – if the bank is betting on Libor falling – is to ensure your bank is one of those whose rates are low. That would pull the average down. "Trimming" so rates that the four high rates and four low rates fall out of the calculation should help avoid falsification but it can be overcome if banks collude with competitors – also suggested.  

Meeting the collusion charge

Because Libor is not regulated, there appears to be a lack of "Chinese walls" at many banks between rate-setters and the traders who can profit if they are "better informed" than rivals.

The UK's FSA is allegedly checking to see if banks trading on their own behalf were able to use Libor information prior to daily publication. If so, counterparties could lose out.  They could sue the banks.  Banks including HSBC, Barclays, and RBS have received requests for information.

The U.S. Securities and Exchange Commission, U.S. Commodity Futures Trading Commission, and Tokyo's Financial Supervisory Agency are all following similar lines. The US Department of Justice has announced a criminal investigation.

At least seven international banks face a Canadian probe into whether they participated in a conspiracy to manipulate prices on interest-rate derivatives. The nation's Competition Bureau is investigating the firms' conduct between 2007 and 2010, according to documents it filed with the Ontario Superior Court in May last year, according to The Globe and Mail (Toronto) .

And a month ago, Swiss based UBS said it had been given conditional immunity from the Swiss Competition Commission as part of an investigation into manipulation of the Yen Libor, Tibor, and Swiss franc Libor rates. The Zurich-based lender was last year granted similar immunity by the U.S. Department of Justice as part of its probes of Yen Libor and Euroyen Tibor rates.

Charles Schwab Corp. (SCHW), the largest independent brokerage by client assets, sued Bank of America Corp., Citigroup Inc. (C) and other banks in August claiming they manipulated Libor from 2007 in violation of U.S. antitrust law. The banks have dismissed this as "without merit".

The FSA is probing whether banks' Libor submissions reflected their actual cost of borrowing and is checking data for anomalies – even checking emails to look for secret codes leading to collusion.

The Swiss competition watchdog reported last month it had opened an inves
tigation into 12 banks, saying "derivative traders might have coordinated the submissions that determine Libor and Tibor to the detriment of their clients,".Many banks have sacked or suspected "rogue traders".

Where is Libor going now?

According to The Financial Times, the most likely way forward is for regulators to start regulating the rates – or at least demanding more information on the process.

And there is a strong likelihood that this will mean the end of the BBA sponsored process – watchdogs may consider that an organisation which lobbies for banks should not be involved in such a delicate rate setting operation, whatever the origins of this practice when Libor had little importance. 

It could also end the Thompson Reuters role in reporting rates and looking at anomalies – or at least it will have to comply with a demand that reports and other investigations are made public. 

 

More from Mindful Money:

Unhedging to investment gains

Transparency is a two-way window

Its the end of the FSA – But will the PRA and FCA do any better?

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