Should it stay or should it go?

Where do we go from here? The events of the last few years have shown us that banks cannot be relied upon to set the LIBOR at its true rate. Not surprisingly a debate has been sparked as to the future of the LIBOR.

A lot of the blame has been placed on financial liberalisation, with Ojo, 2012, stating that the LIBOR fixing was ‘the most lethal consequence’ of deregulation. Although I agree that deregulation has played a strong part in the LIBOR’s fate I feel that the sole blame cannot be placed on it. I tend towards the argument put forward by Philipponat, 2012, that the banks have an ‘in-built conflict of interest’ thus making it near impossible for them to settle on an appropriate rate. He claims that in order for the trust of the general public to be regained in the financial system we must move away from this characteristic. Yesterday, U.S. regulator Gensler, indicated that he too thought that the end of LIBOR, as we know it, was near. Although he felt that it was too big to be abolished, he claimed that a new benchmark was needed at which to set the majority of interest rates.

The Treasury’s reaction to the LIBOR scandal was the publication of the Wheatley Review. The report clearly states that it feels that the regulation of the LIBOR should be reviewed rather than it being replaced. This report set new guidelines as to the regulation of the LIBOR. One of the major changes which the report suggests is that LIBOR should be regulated by the FSA rather than the BBA. This I feel would be a great step towards the rebuilding of trust in the mechanism. It is also suggested that the submission of quotes should be regulated as it is there where the most interference occurs. It does, however, also suggest some alternatives, as can be seen in the box below.

 

I do not think that the end of the LIBOR is in sight despite personally believing that an alternative must be introduced. I am sure that this is not the last time that the LIBOR will be all over our television screens.

Barclays - A Case Study

For those of us sitting at home, watching our TV screens, the unravelling of the LIBOR scandal may have seemed shocking and perhaps even at times exciting. However, for the major players involved in the manipulation, the week beginning the 27^th of June brought a level of stress unknown to them since the collapse of Lehman Brothers.

Barclays Bank has easily become the most prominent of the deceivers. The publication of internal emails blatantly asking for the LIBOR to be fixed at certain rates stunned the world. What I find most troublesome about this was their clear lack of effort to conceal their manipulation. There is no doubt that they felt that there would never be an investigation into their activities.

Here are a few examples of the email content:

“We need a really low 3m fix, it could potentially cost a fortune. Would really appreciate any help."

"Your annoying colleague again ... Would love to get a high one month. Also if poss a low three month ... if poss ... thanks."

The witty replies also show the relaxed attitude to the fixing:

 

"Done ... for you big boy”

“Dude, I owe you big time! Come over one day after work and I'm opening a bottle of Bollinger"

On the 27^th of June 2012 the FSA published a report stating that they had made a settlement with Barclays of £59.5 million. The report found that Barclays had co-operated with its internal derivatives traders in order to set the rate so that it would give them a benefit over other market participants. The London Evening Standard reports that 257 requests were made by derivatives traders, an astonishing figure. The FSA also found evidence that it dealt with various banks in an attempt to fix the rate.

The use of the LIBOR to portray good financial health during the crisis period has shown to come from the direct influence of the Bank of England. To speculate whether this would have occurred without the intervention of the BoE is impossible, and perhaps unfair, to suggest. Paul Tucker, directors of markets for the BoE at the time, instructed Barclays to lower their LIBOR quotes in order to be more in line with other banks. Kregal, 2012, argues that this was a much needed step. In October 2008, when the call was made, Barclays had not sought any financial assistance. Kregal claims that had Barclays continued with the higher LIBOR rates that it could have resulted in the markets fearing the future of Barclays.

The reaction of top management in Barclays to the scandal was apparent shock. The CEO, Bob Diamond, and the chairman, Marcus Agius, denied any involvement in the fixing blaming it on a few rogue traders. Both resigned, nevertheless, shortly after the scam was brought to light. Despite Diamond’s resignation he was granted another 12 months of salary, estimated at £1.35 million. The video below sees Agius vehemently refuting any knowledge of the fixing.  

  

Please take a look at this link to see a Barclays specific timeline.

Uncovering the Truth

A groundbreaking article, published in the Wall Street Journal, in 2008, led the path to revealing the true extent of the current LIBOR fixing. The journalists uncovered the scandal by comparing LIBOR fluctuations to those of the Deposit Insurance market. They found that from January 2008 onwards these rates, which usually moved in tandem, has a less than perfect relationship. Although The Journal hinted, it refused to explicitly state that fixing was occurring, however, it was the catalyst for the investigation which followed. The article showed the extent to which the rates differed to the soundness of the bank.

As early as 2007, there were concerns raised that the LIBOR was in fact being manipulated by the banks. However, these were ignored. It was not until 2010 that the Financial Services Authority began an investigation into the matter. This investigation ultimately led to the fining of $453 million against Barclays. The report revealed that the rigging began in 2005. This delay in reacting has led to widespread criticism of the FSA and other regulatory bodies, however, the FSA has recently denied failing to respond quickly.  

 

The scandal hit the world stage in June of 2012, when within one week emails revealing manipulation were made public, Barclays was forced to pay millions as a result of fixing the rate and a criminal investigation was launched.

To look at a timeline of events, click here.

Empirical research has also been used to investigate what trends had become apparent as the fixing evolved. Snider and Youley, 2012, compare the LIBOR with the EuroDollar market rate, thus comparing the actual rates used with those quoted. Their results indicate, using skewness as a measurement of divergence between the markets, that the difference for some banks was as high as 40 basis points. They also look at the CDS spreads in contrast with the LIBOR given by banks. Intuitively one would imagine that these two would have a positive relationship, however, this, they found, is not always the case. They find that certain banks, Citi in particular, reported a far too low LIBOR relative to their CDS spreads.

Why fix the LIBOR?

The LIBOR has, quite clearly, a substantial effect on the wider economy but why did banks feel the need to fix it? This is of particular relevance as despite banks quoting a particular price they easily could lend at a different rate yet evidently they found it vital.

The period of ‘irrational exuberance’ which led up to the current crisis saw the beginnings of noticeable fixing of the LIBOR rate. Kregal, 2012, claims that there were two stages to the fixing process; the first occurring in the midst of the boom whilst the second began as a result of the bust. This analysis is quite intriguing as it suggests that the initial phase was born out of greed while in comparison the second was due to the breakdown of the short term money markets. The LIBOR is inextricably linked to the US derivatives market acting as a benchmark for transactions occurring within it. Therefore, if fixed it can make the manipulator a fortune. Snider and Youley, 2010, find evidence to suggest that the structure of a bank’s portfolio, and in particular its involvement with derivatives, impacted its calling of the interest rate. What is particularly striking is that, as Choy, Shung, Chng, 2012 comment, in the US it is a federal offence to manipulate the derivatives markets yet this did little to deter the interference.

In recent times, a more rational reason for fixing has evolved. The fear of bank panics, heightened after the bank run on Northern Rock. The subsequent failure of other banks which were often spouted to be as a direct result of bank panics rather than problematic banks, instilled fear in many banks' management. Therefore it is not illogical for banks to decide to portray their LIBOR as far lower than the actual cost at which they were willing to lend. In fact, as Hortacsu, and Kastl, 2009, point out, lending in the interbank market at the height of the crisis was minimal, therefore, the LIBOR was realistically futile.

 

 

The phrase financial liberalisation or deregulation has become synonymous with the Great Crash. The LIBOR could be seen as the very characterisation of this policy. A simple definition of the LIBOR may be termed as banks deciding the interest rate at which to lend to other banks whilst being regulated by a bankers’ association. To those new to the concept, now that the era of deregulation is behind us, this concept must appear strange. It illustrates the power banks had at the beginning of the 21^stcentury. This presents the questions; had the crash not happened would it have been allowed to continue? Did banks fix the rate because they knew they could?

LIBOR's Central Role in the Economy

What is the‘base rate’?
 

In Britain, the Bank of England is responsible for the implementation of monetary policy. The Bank’s Monetary Policy Committee meets on a monthly basis in order to review a key instrument of monetary policy, the base rate. This figure indicates the rate at which the BoE is willing to lend to financial institutions. Despite meeting regularly the MPC have held the interest rate stable, at 0.5%, since the second quarter of 2009. The BoE’s website states that this base rate“affects the whole range of interest rates set by commercial banks, building societies and other institutions for their own savers and borrowers.”Therefore, it is through this rate that the BoE attempts to influence expenditure within the economy and thus, in their eyes, it is central in the transmission of monetary policy.

But how important is this rate for you?

Gaspar and Pérez Quirós, 2004, argue that the interbank market in fact holds“the first step in the monetary transmission mechanism.” As the LIBOR rate reflects the true cost of borrowing for banks, they often pin their interest rates, for both corporate and personal loans, to the LIBOR. This is in particular the case for short term loans; however, many mortgages are also linked to the LIBOR. Therefore, it would appear that it has a great effect on expenditure in the economy. Interestingly the U.S. Commodities Futures Trading Commission claims that in excess of $800 trillion worth of loans are fixed to the LIBOR. This, The Economist notes, is ten times the world economy! The New York Times stated that 45% of prime mortgages, in the U.S., are affected by it and a staggering 80% of subprime mortgages.
 

How is the LIBOR different?

As the interbank market involves unsecured lending, the base rate incurs a risk premium (Christensen, Lopez, Rudebusch, 2009). Thus, during riskier economic periods, interbank rates, such as the LIBOR, are more volatile and see a greater divergence from the base rate. This can be clearly seen from the graph below. So, if your loan is linked to the LIBOR rather than the base rate, tough economic times will become even tougher.

 

 

What is the LIBOR?

Until the summer of last year the London Interbank Offered Rate (LIBOR) was largely unknown to the general public. This is despite it playing a significant financial role in many lives. It can be described as “the rate at which international banks lend to one another in London”, as defined in Brealey, Myers, Allen, 2011. Although technically correct this explanation is too simple as it fails to take into account the wider economic implications of the rate. The LIBOR affects a broad range of interest rates as it acts as a benchmark for many borrowings such as mortgages, student loans etc. Thus the LIBOR affects each and every one of us throughout our lives.

 

 

In the 1980s new financial instruments were introduced into the markets, during this period London became a hub for loan syndication. Banks sought to trade the new instruments but were concerned by the fact that the underlying rates were to be agreed upon prior to trade. This resulted in an appeal to the British Bankers’ Association (BBA) to determine a benchmark interest rate. The LIBOR was subsequently introduced in January 1986, at this time it was solely calculated for three currencies.

 

 

The LIBOR is, these days, calculated at 11am each day by Thomas Reuters. It is estimated for ten different currencies and fifteen various time horizons; these vary from a 24 hour rate to a one year rate. Sixteen major banks, including Barclays and Royal Bank of Scotland, are asked the 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?” The LIBOR is then estimated as the lowest of these rates for each currency and time horizon. This very fact that it is banks, rather than market forces, which determine the rate is what it enables it to be, so easily manipulated.

With this blog I seek to explore the rate's fixing and crucially whether a new system is needed.