One of the biggest financial scams in recent years – the LIBOR-rigging scandal – is back in the news again. What started in 2008 as an investigation into the accuracy of interest rate submissions (for calculation of the Libor) by Barclays, went on to reveal the involvement of some of the world’s largest banks in interest rate manipulations. Adding to the several billion dollars worth of fines already imposed by various regulators, the European Commission, last week, imposed yet another penalty on banks including the Royal Bank of Scotland, Citigroup and Deutsche Bank. So, what is the LIBOR and why was its rigging such a serious offence?
WHAT IS IT The LIBOR or the London Interbank Offered Rate is what the banks charge each other for short-term loans in the London Interbank Market. What makes it so important is that it serves as a global benchmark for short-term interest rates.
Trillions of dollars worth of transactions world-over are based on the LIBOR. It is used as the base rate by banks and other institutions for a number of financial products – loans, deposits, futures and swaps.
For instance, a bank may offer a loan at a floating rate of interest, such as the LIBOR + 3 per cent.
It is also seen as an indicator of the financial health of banks. For instance in early 2008, the LIBOR started to rise, as banks stopped lending amidst revelation that assets held in the form of sub-prime mortgage backed securities could be worthless.
The LIBOR is calculated and published by Thomson Reuters on behalf of the British Bankers’ Association (BBA). It is available for seven different maturities – from overnight to twelve months and in five different currencies including the euro, the US dollar and the pound.
It is based on estimates submitted by banks everyday on rates that they would pay to borrow from each other for different periods and in different currencies.
An average is taken of the rates submitted by the banks, after excluding the extremes (low and high rates), to arrive at the LIBOR.
Following the scam, the BBA (with respect to setting the LIBOR) was brought under the regulatory oversight of the Financial Conduct Authority in the UK. It is now in charge of the LIBOR only till the new administrator takes over. The NYSE Euronext, operator of the New York Stock Exchange (recently acquired by the IntercontinentalExchange), will be taking charge sometime early next year.
The LIBOR scandal, which was revealed in June last year, showed how banks had submitted false numbers to rig the LIBOR to their advantage.
That banks were required to submit estimates and not actual rates, made this manipulation all the more easy. Given the wide usage of LIBOR in global financial markets, the scam had widespread ramifications. A few examples would explain this.
Investigations revealed that the LIBOR rose in the decade following the year 2000, on days when floating home loan interest rates were set for revision. Consequently, banks made profits at the expense of borrowers.
In a similar way, municipalities in the US that had entered into interest rate swaps with banks too lost billions of dollars.
With interest rate swaps linked to the rigged LIBOR, banks were able to reduce their payouts to municipalities, while the municipalities serviced their bonds at a rate not linked to the LIBOR. Last year, home loan borrowers and municipalities in the US filed class action suits against the banks involved.