Fall of Libor

Fall of Libor

An Article on peculiarities of existing financial system published by The Indian Express on July 26, 2012


Prosecutors in the United States and regulators in Europe have begun a widespread criminal investigation into the manipulation of the benchmark interest rate — London Interbank Offer Rate (Libor) — by traders working for global banks. Large-scale arrests could be made in the weeks ahead. Individual arrests will run parallel to regulatory proceedings against top bank managements to determine active collusion in the manipulation of Libor post the global crises of 2008. Libor was like an article of faith for decades as it acted as a benchmark rate for trillions of dollars worth of financial instruments on a daily basis. For instance, an Indian company borrowing three-year money from a European bank would be charged Libor plus 2 or 3 per cent, depending on the company’s own creditworthiness. Even nations borrow from the international market at Libor plus some percentage points.

So in the world of global finance, Libor was implicitly trusted by all. This trust, in a sense, was the long preserved legacy of the western finance capital system. That trust has now somewhat broken down.

In some ways, the Libor scandal dwarfs all other financial scams because it strikes at the very root of the system. To get an idea of the sheer scale of the systemic manipulation one just has to look at the total volume of financial instruments, including derivatives, which were traded on the basis of Libor. According to The Economist, over $800 trillion worth of financial instruments were traded on the basis of Libor.

So if banks understated Libor by 30 basis points (0.3 per cent) the actual impact of this on $800 trillion worth financial instruments could well be over $2.2 trillion. This means there was a gain or loss, depending on which side of the trade you were, of $2.2 trillon — which is more than India’s GDP.

So, one can get some idea of the scale of manipulation that occurs by just artificially lowering Libor by 0.3 per cent. The situation is now ripe for hundreds of class action suits by investors, like pension funds, who may have lost precious money by the understating of Libor by banks.

The circumstances in which Libor was manipulated is also very interesting. It flows directly from the 2008 financial meltdown on Wall Street. To understand how this happened, it is important to know how the Libor is determined purely on a consensus basis every morning at 11 am by the leading global banks. Simply put, some 20 top global banks sit together every morning at 11 am to decide at what rate they will lend to each other for one day. Therefore it is called an inter-bank offer rate. This is done essentially to smooth out short-term liquidity in the banking system as one bank may need urgent cash to meet some overnight exigencies while another may have surplus cash. So the rate at which banks borrow from each other overnight becomes the basis of all other interest rates in the market, whether it is for six months, one-year or five-year loans. This is how Libor affects all other interest rates in about 10 currencies globally.

Libor is determined every day through a consensus process. The British Bankers’ Association asks each bank to put down its own likely cost of borrowing overnight. Different banks give different figures. The top 25 per cent and the bottom 25 per cent rates quoted by banks are cancelled and an average of the middle 50 per cent is taken. In normal times, when the market is healthy and robust, there wouldn’t be much difference between the outlier and average rates. Indeed, they would be very closely aligned, with wafer thin difference, which is also a sign of markets functioning well.

But after the 2008 global crisis the banks went into freeze mode and were not lending to each other freely because of the fear psychosis that money may not come back. The typical fear is you don’t know which bank is in how much trouble. In such a situation, it became difficult for banks to quote exactly what their likely overnight borrowing cost would be for the purpose of determining Libor at 11 am in the morning.

Since normal inter-bank borrowing was not happening after the 2008 Wall Street meltdown, global banks started understating their overnight borrowing rate to just show that they were still in great health. Everybody had a vested interest in stating a lower Libor. The cat was out of the bag recently when Barclays Bank management revealed that it quoted a more genuine Libor rate, which was 30 basis points above all others. In banking, this is quite a big difference and signifies serious abnormality in the financial markets. Eventually Barclays, seeing others were understating, also fell in line. Barclays has now announced an elaborate $150 million investigation into how rogue traders in its own system colluded to manipulate the Libor.

However, it is impossible to imagine that the regulators, and indeed governments, did not have an idea that the inter-bank rate determination had become non-transparent after the global financial meltdown. To give a crude example, determining Libor must have been a bit like discovering real estate prices India where the markets are run by cartels.

Now it is revealed that senior Bank of England officials were warned in an internal note even in 2008 that dishonest estimates of daily borrowing costs were being submitted by banks. At a broader level, one could conclude that the credibility of the famed finance capital institutions created in the 19th century by the white, Protestant business leaders is getting irreversibly damaged now. The New York Times columnist David Brooks puts it succinctly, “Over the past half-century, a more diverse and meritocratic elite has replaced the Protestant Establishment (of the 19th century). People are more likely to rise on the basis of grades, test scores, effort and performance. Yet, as this meritocratic elite has taken over institutions, trust in them has plummeted. It’s not even clear that the brainy elite is doing a better job of running them than the old boys’ network. Would we say that Wall Street is working better now than it did 60 years ago?”

For India, the current state of global finance poses some deep dilemmas. While India cannot disengage from the global finance capital framework as it needs large doses of foreign capital and technologies to fund its growing infrastructure needs, it will have to be far more nuanced in the way it draws its lessons from the current financial system, which is increasingly revealing its rotten core.

The writer is managing editor, ‘The Financial Express’

Published at: http://www.indianexpress.com/news/fall-of-libor/979396/0