The growing kerfuffle over Barclays Bank’s false reporting of its input into the London Interbank Offered Rate (LIBOR) is big news in Europe and among finance specialists in our own country, but it is not on the radar screen of the general public and it isn’t visibly affecting stock or bond markets.
This contrasts with the hullabaloo over JPMorgan’s $2 billion-plus losses in derivatives markets last month.
Yet the U.S. Commodity Futures Trading Commission and Securities and Exchange Commission are playing as large a role as the British bank’s home regulators in investigating what at first glance appears as a dishonest but fairly minor lie about some hypothetical interest rate.
Moreover, both the CEO and chairman of Barclays have resigned in shame while Morgan’s Jamie Dimon was shaken, but certainly not stirred, from his CEO position. What is going on here?
Who actually was harmed by what Barclays and more than 20 other banks did and why should the average American care?
Start with the London Interbank Offered Rate itself. It is more complicated than it may seem.
First, LIBOR encompasses a set of interest rates charged by one London-based bank to another for loans of different terms, from overnight to one year, and for 10 distinct currencies. The most important of these is for overnight loans in pounds sterling. The rates are tabulated daily from data submitted by member institutions of the British Banking Association. Thomson Reuters, a business media group, does the actual compilation and publication every business day. Each specific term-currency pair has a “panel” of eight to 20 “contributor banks.”
Second, contributors don’t report on actual loans they took out that day. Rather, each makes a subjective estimate of the rate at which it “could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to 11:00 London time.” This does not mean, however, that the numbers are pulled out of thin air. Banks that participate in any particular panel are chosen because they are highly active in the market in question and usually make such borrowings multiple times each day.
Third, LIBOR is not easy to manipulate by a single bank because only the middle 50 percent of reported numbers are actually averaged. Submit a very high estimate and it will be discarded along with the upper 25 percent. A lowball will probably fall into the lower 25 percent and also be tossed.
Fourth, submissions are not weighted by each submitting bank’s actual borrowing volumes. So the number sent in by a smaller bank borrowing millions in any one day has the same influence on the tabulated result as one by a bank like Barclays, which may borrow billions.
Beyond these specifics, one must realize that LIBOR quotes are important because they are “reference interest rates.” In other words, interest rates on actual business and household loans including credit cards, auto loans and home mortgages may be set or reset in terms of a number of percentage points above the tabulated LIBOR. And enormous quantities of other financial contracts, including interest rate swaps and other derivative securities, are tied to one or more LIBOR rates.
Not all of these other parties would be affected in the same way by any particular manipulated move in rates. Yes, borrowers with loans the interest on which was tied to LIBOR would be hurt if Barclays or others succeeded in artificially pushing up rates. Their creditors would benefit, at least to the extent that their cost of funds being lent was fixed.
To the extent that the general public is paying attention, there seems to be a perception that this affair involved conspiring to raise interest rates above true market levels and thus fraudulently transfer money from borrowers to creditors. But this seldom happened. In many cases, Barclays and others acted to depress rates rather than lower them. This actually would have benefited business and household borrowers.
Moreover, for nearly any derivative security such as an interest rate swap or credit default swap tied to LIBOR, for every party that gained, there would be a corresponding loser. And the same banks that were reporting interest rates to the Bankers Association also were players in derivative securities markets, trading for their own account. This was particularly true of Barclays, the fourth-biggest bank in the world and a “universal bank” that participates in nearly every imaginable category of financial transactions. Hence, the U.S. Commodity Futures Trading Commission, with growing responsibilities for regulating derivatives trading, has exacted the largest share of the $453 million penalty imposed on Barclays.
Finally, for reasons too complex to detail here, changes in interest rates affect the market value of banks themselves. In this case, lower interest rates tended to boost the price of Barclays stock and higher ones lowered it. So to the extent that Barclays could bring about a change in the tabulated LIBOR, it falsely pushed up its own stock price. This is why the U.S. Securities and Exchange Commission has the second largest fraction of the damages paid by Barclays.
The verb “bring about” a change in LIBOR is important. Huge as Barclays is, it would have been very difficult for it to move LIBOR by itself because of the way high and low reported values are discarded. To have much effect, tacit or overt collusion with other banks was necessary. Here, Barclays’ contention that it was being singled out because it was the first malefactor to fess up has some validity. So much of the story remains untold.
There are broader questions, including ones dealing with national economic policy and the actions of central banks. The assumption is that policies are based on supposedly objective data, like prevailing interest rates, that reflect market realities and not some fraud. This is particularly important during financial crises, such as the fall of 2008. To the extent that fraudulent data leads to bad public policies, society as a whole can suffer. That’s why this is a bigger story than most people yet realize.