Was it a double-whammy that western multinational banks were trying to deliver during the hey-days of Libor-rigging?

Even as they tried to ‘fix’ the Libor (London Interbank Offered Rate) lower, these banks were simultaneously trying to invoke what in syndicated loan agreements is called the ‘market disruption clause’ — stating, in effect, that the Libor was not reflective of the banks’ actual cost of funds.

Market disruption clause

Ever since its emergence as a benchmark interest rate in 1986, all loans in the global financial markets have been linked to Libor. The possibility that the publicly-quoted Libor may not mirror a bank’s actual cost of funds is something that the ‘market disruption clause’ provided for in all international loan documents.

This clause, in sum, would state that if the facility agent (akin to a consortium leader) received notifications from a majority of lenders that the cost of obtaining matching deposits in the interbank market was in excess of Libor, the borrower then had to pay interest for the loan not just at a margin over Libor, but a margin over the individual bank’s cost of funds.

Till 2008, this clause was regarded as a legal boiler-plate without any potential for invocation. The turmoil in the interbank market during the financial crisis of 2008 is what changed this docile provision into a highly contentious issue between lenders and borrowers in the international market.

It is no secret that during this period, the market disruption clause was invoked with impunity in a number of international syndicated loans, forcing borrowers pay higher than the original Libor-linked rates.

More of a ‘guesstimate’

The problem with Libor, of course, was that it was always more of a ‘guesstimate’ than an actual dealt rate. The British Bankers Association (BBA), under whose auspices it was published, merely asked the contributing banks to answer the question: “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 AM (London Time)?”

Implicit in the above question was the fact that the answer being provided was only a perceived rate, with no precise definition of a “reasonable market size” offered either.

Only recently has the world woken up to the reality that it was, indeed, the average of such ‘guesses’ provided by junior-level rate submitters in different banks, which formed the basis for valuation of derivatives and loan transactions running into trillions of dollars worldwide.

While regulators in emerging economies like India look up to the US and the UK for international best practices, the crumbling of the Libor edifice itself points to the West’s “best practices” being somewhat hyped and overrated at times.

Even though the rigging here may have been formally done by junior staff, the culpability lies with the big banks concerned, and not at the individual level.

This is what the British banking giant, Barclays, at least has admitted to as much in the non-prosecution agreement on June 26 that it reached with the Criminal Division (Fraud Section) of the US Department of Justice’s Criminal Division.

The agreement stated “Barclays acknowledges that the participating employees intended, at least in part, to benefit Barclays…and due to the misconduct Barclays has been exposed to substantial financial risk.”

Reforming Libor

It is also a fact that the above practices, not specific to Barclays alone, were not totally unknown to global market regulators even during 2008.

On July 20, the Bank of England (BoE) released an exhaustive e-mail chain running into 80 pages, revealing how the agenda of reforming Libor had drawn the attention of the likes of its governor, Sir Mervyn King, and his deputy, Paul Tucker, apart from Tim Geithner, who was then President of the New York Federal Reserve and currently US Treasury Secretary.

In an e-mail dated June 1, 2008, Tim Geithner put forth six major recommendations for enhancing the credibility of Libor. None of these was or has been implemented. Even the BoE Governor himself had written on one of the emails concerning a BBA review of Libor that: “This seems wholly inadequate. What should we do?”

At the same time, the Libor was a baby that the regulators did not want to directly own. This was something that the BoE seemed to underline even its recent statements. To quote from its July 20 release itself: “Because the Libor system was, and is a private sector arrangement and was not subject to financial regulation, it was not appropriate for the public authorities to endorse or determine the outcome of the BBA Review.”

While the Libor scandal has so far largely focused on the shenanigans behind the ‘setting’ of the rate, the practice among the same big global banks rushing to invoke the ‘market disruption clause’ has, however, somehow escaped global attention. This author recalls especially how, in those tumultuous days, the State Bank of India (SBI) was an honorary exception to the double game being played of ‘submitting’ a lower rate and then invoking the ‘market disruption clause’ to charge a higher rate.

Deft management

SBI’s International Banking Group (IBG), then, took the principled stand that it would not be a party to the invocation of the controversial clause in syndicated foreign currency loans where it was a participant-lender, mainly to Indian corporates. The then head of the IBG, incidentally, was the current SBI Chairman, Pratip Chaudhuri!

Together with the deft monetary management that the Reserve Bank of India under Y. V. Reddy displayed in 2008-09, the ethical practices of banks like SBI, for those times, provide instances that the Indian financial sector can justifiably be proud of.

And it also evidence that our own practices are sometimes as or much superior to those deemed as best of the West.

(The author is with State Bank of Mysore. The views are personal.)

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