Libor: Three Scandals in One
Governments in Europe, Japan, and the United States are now investigating 16 major banks for manipulating interest rates. In the months leading up to the 2008 financial crisis, many of the world’s most powerful financial institutions allegedly worked to keep down the London Interbank Offered Rate. Libor, as it is known, is supposed to be the average rate at which the largest and ostensibly safest banks in the world can borrow from one another. Manipulating Libor allowed traders to rig financial markets to their advantage; in the process, they distorted the actual value of key financial instruments such as credit default swaps, derivatives, and home mortgages.
The scandal has sparked calls from politicians, including Mervyn King, the governor of the Bank of England, for stronger regulation of the world’s most powerful banks. But such proposals miss a key point: Price fixing and manipulation are illegal. They have been for a long time. So it is unlikely that saddling financial markets with legal constraints that simply double down on what is already on the books will help. A better solution would go to the heart of the problem. Regulators and market participants should set such benchmark interest rates as Libor in a way that makes them reflect movements in the market, making manipulation impossible.
The fundamental principle underlying floating rates is to allow the market to determine borrowing costs. Customers who borrow on a floating-rate basis, if they are sensible, and institutions that loan money on a floating-rate basis, if they are ethical, therefore expect two things from a benchmark interest rate. First, the benchmark should reflect actual conditions in the financial markets. That means no random fluctuations — money costs what it is worth. Second, the benchmark rate should not be easy to manipulate. No rational, informed borrower would borrow money at a variable rate of interest and then empower the lender to determine when and how the interest rate changed in the future.
So it is startling that Libor, the financial world’s most important number, satisfies neither of these requirements. Libor is computed by the British Bankers’ Association (BBA), a powerful trade association based in London that represents more than 250 financial institutions. These banks are located in 50 countries and have operations in just about every corner of the globe. But instead of using actual market rates, big banks estimate the interest rate that they think they would have to pay if they borrowed money from other institutions. That is different than reporting the actual interest rate at which they are really borrowing from other banks.
Each day, the BBA sets Libor rates for 15 loan maturities in ten different currencies. In the case of the dollar, 18 banks submit their hypothetical borrowing costs. The BBA discards the four highest and the four lowest submissions, which is supposed to prevent a small number of anomalous results from distorting the calculation, and then averages the remaining ten to come up with the Libor number. Thompson Reuters calculates all of these rates for the BBA, and then publishes the results, usually around 11:45 AM (CET).