LIBOR - with special reference to its

recent abuse
- Mayank Shah, PGDM-FS, (60)

T he scandal surrounding Barclays PLC has already created turmoil in the British
banking giant’s executive suite – but it could reach much further before it’s resolved.
Barclays chairman Marcus Agius resigned on Monday, but then agreed to stay on as
the company searches for a replacement for CEO Bob Diamond, who abruptly resigned under
pressure the following day. Chief Operating Officer Jerry del Missier also stepped down.
Many more heads could roll if the rate-rigging scandal mushrooms, but even as it is, the
investigations into Barclays and other banks manipulation of a key interest rate called Libor
has wide-reaching implications for the financial sector – and for millions of businesses and
consumers in the U.S. and abroad. Here, a guide to the scandal and its potential fallout.

What Is Libor?
The London Interbank Offered Rate, or Libor, is a key short-term interest rate that reflects the
rates that banks get when they borrow from each other day-to-day. The interbank borrowing
is done by financial institutions looking to make profits or cover short-term liquidity
shortfalls. The British Bankers’ Association actually tracks a range of rates calculated daily
for 10 major currencies and 15 borrowing periods – from overnight to 12-month loans – so
150 numbers are published every day: the overnight euro rate, the two-week Yen rate, the 3-
month New Zealand dollar rate, the 12-month U.S. dollar rate, etc.

How Is the Libor Rate Set?

Thomson Reuters calculates and publishes the rate for the British Bankers’ Association every
day just after 11 a.m. The calculation of U.S. Dollar Libor is based on data submitted every
day, except for bank holidays, from a panel of 16 major financial institutions. The banks are
asked to base their submission on this 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?” Thomson Reuters throws out the top and bottom quarter of submissions
and averages the remaining eight to get the published rates. That process, however, means
that Libor is based on the rates banks report they could get, not actual rates on real loans.

Why Does Libor Matter?

Libor “is used to set interest rates on $350 trillion of dollars and euros of loans and other
obligations globally,” portfolio manager Michael Lewitt of Cumberland Advisors wrote in a
note to clients this week. That’s about $50,000 worth of financial instruments for every
person on Earth. Libor plays a key role in global financial markets, underpinning the interest-
rate derivatives traded by large institutions. And in addition to reflecting the rates that banks
get from each other, Libor is also used to determine rates for some types of loans to
consumers and businesses. “Adjustable-rate mortgages, student loans, some credit cards as
well as small-business loans and corporate bond offerings can all be pegged to Libor,” says
Greg McBride, senior financial analyst at Bankrate.com. In the United States, though, Libor
is not the primary index for most loans, McBride notes.Still, if Libor is used as a global
benchmark, the rate-rigging scandal calls into question the reliability of that benchmark – an
issue that had also gotten attention during the financial crisis – and could potentially affect
the interest rates many consumers pay.

What Did Barclays Do?

Last week, Barclays settled charges that it manipulated the Libor rate, and a similar rate
called Euribor, for its own benefit by submitting falsified numbers as far back as 2005.
According to the Financial Services Authority, Barclays derivatives traders routinely asked
for submitters to help them profit from their trades by sending in numbers that were either
higher or lower than they should have been. The regulator’s report says Barclays submitted
inaccurate rates “on numerous occasions” between January 2005 and July 2008 at the behest
of at least 14 Barclays derivatives traders. “Barclays could have benefitted from this
misconduct to the detriment of other market participants. Where Barclays acted in concert
with other banks, the risk of manipulation increased materially,” according to the FSA. At
times, the Barclays traders also tried to influence the submissions of other banks, and passed
along requests from their counterparts to Barclays submitters. After a Barclays submission
was lower, as requested, one of those outside traders emailed their contact: “Dude. I owe you
big time! Come over one day after work and I’m opening a bottle of Bollinger.”
Then, during the financial crisis, after media reports questioned whether Barclays’ higher
submissions for Dollar Libor indicated that the bank had a liquidity problem – whether other
banks were wary of lending it money – the bank began sending in lowball numbers meant to
ease concerns about its cost of borrowing. “At the height of the financial crisis, Libor was
viewed by the markets as a key barometer of UK banks’ financial health,” writes Lewitt.
“The higher a bank’s Libor lending rate, the more fragile its financial condition was believed
to be.” The artificially low submissions were done at the direction of Barclays’ senior
management, according to U.S. and U.K. authorities.

In announcing the settlement with Barclays, the authorities made a point of noting the bank’s
“extraordinary cooperation” with their investigation. In light of that cooperation, the Justice
Department agreed not to prosecute the bank if it meets its “ongoing obligations under the
agreement” for two years.

How Has Barclays Been Punished?

In settling the charges against Barclays, the U.K.’s Financial Services Authority (FSA)
imposed a penalty of £59.5 million (about $92 million). The U.S. Commodities Futures
Trading Commission ordered Barclays to pay a $200 million penalty, and the Justice
Department imposed a $160 million penalty. In all, Barclays agreed to pay more than $450
million.

Were Other Banks Involved?

“Barclays are not alone in this,” Britain’s chancellor of the Exchequer George Osborne said
in a statement released last week. “The FSA is continuing to investigate the conduct of a
number of other banks in relation to Libor… The investigations concern a number of
institutions both based in the UK and overseas.” Regulators in the U.K., U.S. and Asia are
reportedly investigating potential rate-rigging by more than a dozen other financial giants.
Some of the banks whose names have come up in connection to the investigation include
Bank of America, Citigroup, HSBC, the Royal Bank of Scotland and UBS.

Barclays and its ex-CEO certainly believe they weren’t alone in fixing rates. “This isn’t just
Barclays,” Diamond said at his hearing before Parliament’s Treasury Select Committee.
“Throughout 2007 and 2008, no institution of the 16 banks reporting three-month dollar
Libor was at the higher end more consistently than Barclays." How far did the malfeasance
go? “There appear to be mountains of evidence that the conduct in question was intentional
and widespread, both within and among major banking institutions in the UK and likely the
U.S.,” Cumberland Advisors’ Lewitt wrote. In the U.S., big banks including Barclays, Bank
of America, Citigroup, Credit Suisse, Deutsche Bank, HSBC, Lloyds Banking Group,
JPMorgan Chase, Royal Bank of Scotland and UBS face lawsuits over the Libor rate-fixing.
Those suits could end up costing more than any penalties imposed by regulators.

Who Else Could Get Caught Up in This?

The scandal also threatens to tarnish financial authorities. Barclays employees had raised
concerns with regulators in 2007 and 2008 that the Libor submissions from banks, including
their own, might not accurately reflect the market. And documents released by Barclays
suggested that the bank may have lowered its submission figures during the financial crisis in
response to an October 2008 call from Paul Tucker, the deputy governor of the Bank of
England, the country’s central bank — but in his appearance before Parliament on
Wednesday, former CEO Diamond said he did not interpret the call that way. Tucker has
requested a hearing to offer his version of the conversation and related events. He’ll have his
chance next week. In the meantime, a Bank of England spokesman said this week that, "It is
nonsense to suggest that the Bank of England was aware of any impropriety in the setting of
Libor."

What Happens Next?

Investigators will continue to probe the extent to which other banks were involved in rate-
fixing. “If it was just one or two banks then the likelihood that there was any material impact
on consumer or corporate borrowers was very, very slim,” says McBride. “If it mushrooms
into a situation where a multitude of financial institutions were complicit then it does far
more than undermine the integrity of financial markets – you’re talking about real world
dollar impact on borrowers around the globe.” In the meantime, the British Bankers’
Association, which said in a statement released last week that it was “shocked” by the report
about rate-rigging, asked authorities to examine whether changes should be made to the
process used for setting Libor.