In 2012, an international investigation into the manipulation of interbank offered lending rates revealed a widespread plot undertaken by multiple banks—most notably Barclays, UBS, Rabobank, and the Royal Bank of Scotland—to leverage these interest rates for profit. Investigations are expected to further implicate other global financial institutions and may expose them to losses from civil lawsuits by their clients and investors.
Regulators in the United States, UK, and EU fined banks more than $6 billion for rigging interest rates. Barclays agreed in late June 2012 to pay a $453 million fine to settle allegations that it had systematically manipulated the London Interbank Offered Rate, or Libor, between 2005 and 2009. The firm was also fined for "misconduct" related to the European equivalent of Libor, the Euro Interbank Offered Rate (Euribor). By November 2013, RBS, UBS, Rabobank, and UK broker ICAP were all facing large fines, bringing the total penalties paid in Libor settlements to more than $3.7 billion, a figure that could rise as financial firms continue to grapple with lawsuits. European regulators fined a group of banks, including Deutsche Bank, JP Morgan, and Societé Générale, $2.3 billion in December 2013. Several bankers and traders have also been brought up on criminal charges.
What is Libor?
Libor is a benchmark interest rate based on the rates at which banks lend unsecured funds to each other on the London interbank market, and is published daily by the British Bankers' Association (BBA). Each morning, global banks submit their borrowing costs to the Thomson Reuters data collection service. The calculation agent throws out the highest and lowest 25 percent of submissions and then averages the remaining rates to determine Libor. Calculated for fifteen different maturities and ten different currencies, Libor is considered the most critical global benchmark for short-term interest rates. Eighteen banks submit rates for the U.S. dollar Libor.
How does Libor affect global borrowing?
Many banks worldwide use Libor as a base rate for setting interest rates on consumer and corporate loans. Indeed, hundreds of trillions of dollars in securities and loans are linked to Libor, including auto and home loans, according to the U.S. Commodities Futures Trading Commission. When Libor rises, rates and payments on loans often increase; likewise, they fall when Libor goes down. Libor "is used for an increasing range of retail products such as mortgages and college loans," while also being used as "the basis for settlement of interest rate contracts on many of the world's major futures and options exchanges," explains the BBA. Some 45 percent of adjustable-rate prime mortgages and 80 percent of adjustable-rate subprime mortgages are based on Libor, while half of variable-rate private student loans are set to Libor.
Why and how did traders potentially manipulate Libor?
Barclays and fifteen other global financial institutions have been under international investigation by a handful of regulatory authorities—including those of the United States, UK, Switzerland, Canada, and Japan—for allegedly manipulating the Libor rate between 2005 and 2009. Barclays reportedly first manipulated Libor during the global economic upswing of 2005–2007 so that its traders could make profits on derivatives pegged to the base rate, explains CFR's Sebastian Mallaby. During that period, "swaps traders often asked the Barclays employees who submitted the rates to provide figures that would benefit the traders, instead of submitting the rates the bank would actually pay to borrow money," the New York Times noted. Moreover, "certain traders at Barclays coordinated with other banks to alter their rates as well." During this period, Libor was maneuvered both upward and downward based "entirely on a trader's position," explains the London School of Economics' Ronald Anderson.
"It distorts trust in the marketplace if you can't trust the rates at which banks are lending to one another." – Thomas Cooley, New York University
Following the onset of the global financial crisis of 2007–2008, Mallaby says, Barclays manipulated Libor downward by telling Libor calculators that it could borrow money at relatively inexpensive rates to make the bank appear less risky and insulate itself. The artificially low rates submitted by Barclays came during an "unprecedented period of disruption," says Anderson. It provided the bank with a "degree of stability in an unstable time," he says.
The investigation into UBS focused on trader Thomas Hayes, whose alleged rigging led him to post profits in the hundreds of millions for the bank over his three-year stint. After Hayes was arrested in December 2012, UBS executives took the blame for creating a system in which traders were rewarded with large bonuses if they agreed to take part in the scheme. At the same time, collusion allegedly occurred between Hayes and traders at RBS, which is 81 percent owned by British taxpayers, in order to affect submissions across multiple institutions. In February 2013, British chancellor of the exchequer George Osborne announced that he wanted the fine for RBS to come out of bankers' bonuses.
What effect has the Libor scandal had on global financial markets?
"It distorts trust in the marketplace if you can't trust the rates at which banks are lending to one another," says Thomas Cooley of New York University's Stern School of Business. The Wall Street Journal's Francesco Guerrera wrote that Libor manipulation meant "trillions of dollars of financial instruments were priced at the wrong rate—a fact that could do wonders for plaintiffs' lawyers while undermining investors' confidence in financial markets." Indeed, securities broker and investment bank Keefe, Bruyette & Woods estimated that the banks being investigated for Libor manipulation could end up paying an approximate $35 billion in legal settlements, separate from any payments to regulators.
"Relative to the size of the sixteen banks at risk of lawsuits in the Libor scandal, $35 billion is chump change. But it will be another blow to the banks' ability to hold enough capital to satisfy higher regulatory requirements in the wake of the financial crisis," wrote the Huffington Post's Mark Gongloff.
What are some implications of the Libor scandal for bank regulatory policies?
The settlement between Barclays and the Commodity Futures Trading Commission holds the "seeds" of a new regulatory regime, said Guerrera. Barclays "must now base its submissions on market prices rather than some hazy estimate of borrowing costs," he wrote, adding that "if more settlements materialize, these rules likely will end up applying to other banks." Similarly, LSE's Anderson notes that the Libor-setting process is "by design not based on real transactions." Part of the solution, he argues, is to have Libor set according to actual borrowing and lending done by banks, so that "the rate being quoted is based at that which people do business."
At the same time, leading central banks "dropped the ball badly," according to NYU's Cooley. The New York Federal Reserve, for example, knew Libor was "not reliable," he says, but it never followed up with the Bank of England after sending a letter and list of suggested recommendations for "enhancing the credibility" of the Libor regime in 2008. Central banks have an obligation to "monitor the integrity of rates that function as Libor does," Cooley argues. Timothy Geithner and Mervyn King, the respective heads of the New York Federal Reserve and Bank of England when the correspondence occurred, have come under fire for failing to push forward reforms despite having knowledge of Libor's flawed reporting system.
A rift has emerged between regulators in Europe and the United States on possible changes to Libor. The prevailing sentiment in the United States is that Libor has been discredited and should be scrapped in favor of a new rate based on real transaction data, with the GCF Repo index, published by the Depository Trust & Clearing Corporation, as a possible candidate. Regulators in Britain advocate a gradual shift that would keep the Libor mechanism for existing contracts and allow new contracts to use Libor or a transaction-based benchmark rate until a full overhaul of the system is completed.
*Andrew Godinich contributed to this report.
The Congressional Research Service answers some frequently asked questions about Libor.
This New York Times infographic illustrates the complicated process used to manipulate the interest rate.
Donald MacKenzie explains the significance of Libor in this London Review of Books essay.
The Economist examines the global scope of the Libor scandal.