Libor manipulation

Latest financial scandal calls into question whose bottom line matters most to whom

Sorting through the intricacies of the financial markets is no picnic, and any one slice of the industry provides enough acronyms, regulatory alphabet soup and financial product jargon to glaze the eyes of most casual observers. Given that context, it is not surprising that the Libor, or London Interbank Offered Rate, scandal took time to gain traction in the public’s mind.

That it took almost as long to gain regulators’ attention, though, is another matter and one that raises the familiar question of how to keep banks and the finance industry behaving as they should when there are billions of dollars in incentives to game the system just a little. In the case of Libor, it appears, the temptation was too great.

The rate is based on a daily survey of up to 18 banks on what it would cost them to borrow money. That survey then provides the baseline on which rates are set for any number of borrowing and investment arrangements: credit cards, student loans, car loans, derivatives. The process is overseen by the British Bankers’ Association, but it appears that the inner workings of the rate reporting takes place under the association’s radar, in the form of what is being called collusion among the surveyed banks. Investigators are finding that banks, most prominently Barclays Capital, which settled with U.S. and British regulators for $453 million after admitting it worked with other banks to manipulate the rate to benefit its positions. Those other banks, including JPMorgan Chase, Deutsche Bank and Citigroup, are also under investigation for their role in the rate-setting.

At stake are billions of dollars that banks may have conspired to earn in market conditions that were less than free. If interest rates were manipulated to benefit trading positions – to the tune of $350 trillion in derivatives linked to Libor – that can hardly be called the result of a free market. On the other side of the rates, of course, are borrowers paying higher interest or markets taking confidence cues based on unrealistically low rates being reported by the banks. Essentially, they were working both sides of the equation: boosting investor confidence by reporting artificially low borrowing rates when the markets looked shaky, and falsely inflating them when it benefitted investment positions. Taken together, this not-quite-honest rate-setting process manipulates far more than interest levels; it undermines the integrity of the markets as a whole.

And integrity aside, it appears this sleight of hand cost investors and borrowers billions. As CNN reported, the Libor fallout is likely to be big – huge, even. “This dwarfs by orders of magnitude any financial scams in the history of markets,” said Andrew Lo, a professor of finance at the Massachusetts Institute of Technology in a CNN report on the scandal.

That is saying something, given the size, scope and scale of some of the more recent financial disasasters like the 2008 mortgage crisis and subsequent collapse of several financial giants, for example.

As with most things market-related, though, there is a zero sum at the end of the equation, meaning that for every dollar lost or overcharged on interest someone else made a dollar. It is not difficult to surmise where the banks came out in that math. What is a greater challenge is crafting and implementing guidelines and regulations that effectively prevent such shenanigans, rather than try to respond to them after the money’s gone.