August 27, 2012

Not Enough Interest

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At 11 a.m. every morning for the past 26 years, the news agency Thomson Reuters has released a set of interest rates on behalf of the British Bankers Association. Known as the London Inter-bank offered Rate (LIBOR), this set of rates has affected financial markets in myriad complex ways. The essence of its impact stems from the fact that LIBOR, expressed for many different currencies and for many different repayment schedules, is the rate at which banks can borrow money. Interbank lending is crucial for the health of the banking sector. Your bank keeps liquid reserves to make sure that the checks you write and the credit and debit cards you swipe can be honored. In the event that they begin to run out of these reserves, however, banks have the ability to borrow from each other. The LIBOR rate is the cost of this borrowing. If it rises, banks all around will spend more to meet daily requirements, increasing the cost that you and I have to pay to take out loans from our banks. Not surprisingly, a rise in this rate hurts the overall economy because consumers begin to spend less and producers invest less.

In May 2008, The Wall Street Journal ran a story that suggested LIBOR rates might have been consistently underestimated in the aftermath of Lehman Brothers’ bankruptcy. The story was rubbished by reputed agencies like the Bank of International Settlements and the International Monetary Fund. In fact, the story turned out to have some merit. Earlier this year, it was revealed that the U.S. Department of Justice was investigating possible LIBOR manipulation. In June, Barclays Bank became the first financial institution directly implicated in LIBOR manipulation. It was fined a cumulative $450 million by American and British regulators.

To understand the accusations against Barclays, one needs to understand the method of setting LIBOR rates. It remains an unbelievably anachronistic ritual in an industry that is dominated in the popular imagination by supercomputers, programmed by quants, trading intimidatingly complex financial derivatives. Eighteen banks report to Reuters the interest rate at which they expect to be lent money. Reuters discards the highest and lowest four quotes and averages the rest. This rate serves as the benchmark for interbank borrowing for the following 24 hours.

One needs little formal expertise to see that this system is ripe for exploitation. The first, more obvious, route to manipulation is by artificially lowering the rate you report. That the rate might not actually fall (your “low” quote might be discarded being one of the lowest four) does not matter. It indicates the financial health of your institution and this helps builds trust with other sources of funds, lowering the price you must pay to borrow from them.

The second route is vastly more devious. With increasingly complex financial engineering, capital markets today trade in many instruments and derivatives whose values are dependent on the whims of these 18 banks. For instance, small businesses that export to or import from other countries usually use “forward rate agreements” to protect against dramatic changes in exchange rates. The costs of these agreements are strongly impacted by changes in LIBOR. Similarly, derivatives called interest rate swaps that have a gross market value touching $14 trillion also use LIBOR as a reference rate. Banks that have engaged in such transactions stand to gain massively from the slightest deviation in LIBOR if learned about in advance.

Barclays, along with other banks, is accused of engaging in both kinds of manipulation and there is some evidence to suggest that the Bank of England might have covertly supported the first kind. In the worst months of the crisis when interbank lending had frozen, the central bank might have seen some merit in a lower-than-actual LIBOR to boost market confidence. While this might prove a mitigating circumstance in some court of law for Barclays, it must not be twisted into a defense of a system that is problematic by construction. So long as the road to monetary management for the central bank remains inextricable from a route to private profiteering, the road needs to be shut.

The LIBOR scandal raises two more red flags that any reform proposals must consider. I alluded to the first one earlier: obscurity bears little correspondence with triviality. The topics in financial sector reform that capture public imagination, such as outsized executive bonuses and “too big to fail” banks, are tremendously important to address. However, we also need to grasp at the grimy underpinnings of strategies adopted by these oft-vilified institutions. The LIBOR estimation procedure is a prime candidate.

Second, for all the talk of the industry’s domination by impersonal supercomputers that exploit, profit from and thereby eliminate imperfections in the market, it simply is not so. When a key parameter like LIBOR is determined by the voluntary input of just 18 voices, each quoting a self-interested figure, substantial opportunities for arbitrage persist in the hands of those who have a say in the process. This scandal was a level above insider trading rackets. Not only were the accused parties illegally using information, they were creating information tailored to their needs.

The deeply entrenched nature of LIBOR means that the fixes are likely to only tweak the system, such as including more banks in the determination process. Even if this prevents future manipulation, some losses will not find easy reparation. Prime among these is the loss of trust in regulators like the Bank of England. At a time when central banks increasingly rely on this credibility to get financial institutions to do their bidding, this destruction of credibility might be yet more lamentable than the profits Barclays wrongly wrangled.

Kirat Singh is a junior in the College of Arts and Sciences. He may be reached at ksingh@cornellsun.com. Evaluating the Discontents appears alternate Tuesdays this semester.

Original Author: Kirat Singh

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