The most memorable incidents in Earth-changing events are sometimes the most banal. In the rapidly spreading scandal of LIBOR (the London interbank offered rate), it is the very everydayness with which bank traders set about manipulating the most important figure in finance.
They joked, or offered small favors. "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. One trader posted diary notes to himself so that he wouldn't forget to fiddle the numbers the next week. "Ask for High 6M Fix," he entered in his calendar, as he might have put "Buy milk."
What may still seem to many to be a parochial affair involving Barclays, a 300-year-old British bank, rigging an obscure number, is beginning to assume global significance. The number that the traders were toying with determines the prices that people and corporations around the world pay for loans or receive for their savings.
It is used as a benchmark to set payments on about $800 trillion-worth of financial instruments, ranging from complex interest rate derivatives to simple mortgages. The number determines the global flow of billions of dollars each year. Yet it turns out to have been flawed.
Damning evidence has emerged, in documents detailing a settlement between Barclays and regulators in America and Britain, that employees at the bank and at several other banks tried to rig the number time and again over a period of at least five years. And worse is likely to emerge. 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. "This is the banking industry's tobacco moment," says the chief executive of a multinational bank, referring to the lawsuits and settlements that cost America's tobacco industry more than $200 billion in 1998. "It's that big," he says. The scandal corrodes further what little remains of public trust in banks and those who run them.
LIBOR is something of an anachronism, a throwback to a time in London when many bankers within the City's Square Mile knew one another and when trust was more important than contract. For LIBOR, a borrowing rate is set daily by a panel of banks for 10 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 11 a.m. 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.
In theory, LIBOR is supposed to be a pretty honest number because it is assumed, for a start, that banks play by the rules and give truthful estimates. The market is also sufficiently small that most banks are presumed to know what the others are doing. In reality, the system is rotten. First, it is based on banks' estimates, rather than the actual prices at which banks have lent to or borrowed from one another.
A second problem is that those involved in setting the rates have often had every incentive to lie, since their banks stood to profit or lose money depending on the level at which LIBOR was set each day.
Worse still, transparency in the mechanism of setting rates may well have exacerbated the tendency to lie, rather than suppressed it. Banks that were weak would not have wanted to signal that fact widely in markets by submitting honest estimates of the high price they would have to pay to borrow, if they could borrow at all.
In the case of Barclays, two very different sorts of rate fiddling have emerged. The first sort, and the one that has raised the most ire, involved groups of derivatives traders at Barclays and several other unnamed banks trying to influence the final LIBOR fixing to increase profits (or reduce losses) on their derivative exposures. The sums involved might have been huge. Barclays was a leading trader of these sorts of derivatives, and even relatively small moves in the final value of LIBOR could have resulted in daily profits or losses worth millions of dollars.
In 2007, for instance, the loss (or gain) that Barclays stood to make from normal moves in interest rates over any given day was $40 million at the time. In settlements with the Financial Services Authority in Britain and America's Department of Justice, Barclays accepted that its traders had manipulated rates on hundreds of occasions. Risibly, Bob Diamond, its chief executive, who resigned on July 3 as a result of the scandal, retorted in a memo to staff that "on the majority of days, no requests were made at all" to manipulate the rate. This was rather like an adulterer saying that he was faithful on most days.
Barclays has tried its best to present these incidents as the actions of a few rogue traders. Yet the brazenness with which employees on various Barclays trading floors colluded, both with one another and with traders from other banks, suggests that this sort of behavior was, if not widespread, at least widely tolerated. Traders happily put in writing requests that were either illegal or, at the very least, morally questionable. In one instance a trader would regularly shout out to colleagues that he was trying to manipulate the rate to a particular level, to check whether they had any conflicting requests.
Galling as the revelations are of traders trying to manipulate rates for personal gain, the actual harm done would probably have paled in comparison with the subsequent misconduct of the banks. Traders acting at one bank, or even with the clubby co-operation of counterparts at rival banks, would have been able to move the final LIBOR rate by only one or two hundredths of a percentage point (or one to two basis points).
'Clean in principle'
But 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 (although there is also a twist in this part of the story involving the regulators).
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 systemwide. 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.
Confounding the issue is the question of whether Barclays had, or thought it had, the tacit support of both its regulator and the Bank of England. In notes taken by Diamond, then the head of the investment-banking division of Barclays, of a call with Paul Tucker, then a senior official at the Bank of England, Diamond recorded what was interpreted by some in the bank as a nudge and a wink from the central bank to fudge the numbers. The next day the Barclays submissions to LIBOR were lower. This could be a crucial part of the bank's defense.
Regulators around the world have woken up, belatedly, to the possibility that these vital markets may have been rigged by a large number of banks. The regulatory machinery will grind slowly.
The revelations raise difficult questions for regulators. An issue is the conflict central banks face, in times of systemic banking crises, between maintaining financial stability and allowing markets to operate transparently. Whether the Bank of England instructed Barclays to lower its submissions or not, regulators had a pretty clear motive for wanting lower LIBOR: British banks, in effect, were being shut out of the markets.
This highlights a deeper question: What is the right level of involvement in influencing or regulating market interest rates, in a crisis, by those responsible for financial stability? Central banks get a slew of sensitive information from banks which they rightly do not want to make public. Data on deposit outflows at banks could trigger unnecessary runs, for example. Yet LIBOR is a measure of market rates, not those picked by policymakers.
Two big changes are needed. The first is to base the rate on actual lending data where possible. Some markets are thinly traded, though, and so some hypothetical or expected rates may need to be used to create a complete set of benchmarks. So a second big change is needed. Because banks have an incentive to influence LIBOR, a new system needs to explicitly promote truth-telling and reduce the possibilities for co-ordination of quotes.
Ideas for how to do this are starting to appear. Rosa Abrantes-Metz of NYU's Stern School of Business was one of a group of academics who, in 2009, raised the alarm that something fishy was going on with LIBOR. One simple change, she proposes, would be significantly to raise the number of banks in the panel.
The theoretical changes needed to repair LIBOR are not difficult, but there are practical challenges to reform. The thousands of contracts that use it as a point of reference may need to be changed. Moreover, the real obstacle to change is not a lack of good ideas, but a lack of will by the banks involved to overturn a system that has served most of them rather well. With lawsuits and prosecutions gathering pace, those involved in setting the key rate in finance need to get moving. Adding a calendar note to "Fix LIBOR" just won't do.
© 2012 The Economist