Libor: The number at the centre of a scandal

What's been going on?

Some of the world's biggest financial institutions are being sucked into a wide-reaching investigation by regulators across the globe into whether they rigged one of the most important interest rates in financial markets Libor. The investigation centres on the period 2006-2008 just before and during the financial crisis and is looking to see if banks manipulated Libor to hide the truth about their finances and to boost the profits of their trading arms. If found guilty, then it will be another black mark against the big banks, and could expose them to a "legal and regulatory bonanza", as the Financial Times puts it. It also raises questions about how useful Libor is as a benchmark.

What is Libor?

Libor stands for the "London interbank offered rate". It is a rate of interest produced in ten currencies for 15 different time periods ranging from overnight to one year, giving 150 different rates in total. Published every working day at 11am, it is meant to give an average rate at which a bank can get unsecured financing for a given period in a particular currency.

Information is collected every morning from a panel of leading banks. Thomson Reuters, on behalf of the British Bankers Association (BBA), asks these banks to submit a series of interest rates that reflect the cost of borrowing funds from other banks over different time periods.

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Say there are 16 banks in the panel. The four highest and four lowest rates are discarded. An average of the middle eight rates is then taken to determine that day's Libor for each currency and time period. The whole submission process is supposed to be confidential, with banks only able to see others' submissions after the official data has been made public.

Why does Libor matter?

Libor is used to set the interest rates on around $360trn of financial products worldwide, including mortgages, loans, credit cards and derivative products, such as futures and options. So it has a direct impact on the finances of most companies and individuals.

For example, company loans are often priced at a certain amount above Libor. A very safe company might pay Libor + 0.5%, whereas a solid but more risky one might pay Libor +2.5%. It is also used as a check on the health of the financial system. During times of financial distress, banks become more wary of lending to one another as they fear their loans might not be repaid. This is usually reflected by a rising Libor.

Why manipulate the rate?

A key criticism of Libor is that it is not based on actual transactions, but on hypothetical ones. This is because not all banks will always want to borrow money in certain currencies or over certain time periods, so there may not be any real-world' data. But it does leave the potential for abuse. Because the highest and lowest data points are excluded from the calculation, it is theoretically possible to manipulate Libor.

For example, a bank in financial difficulty may not be able to borrow at low rates. But by submitting an artificially low rate into the daily panel process, it will probably be thrown out as part of the lowest 25% of rates. This will then be replaced by another low rate that will drag down the average. The end result is that Libor and a bank's financing costs would be lower than they should be, and the bank's profits higher.

A bank might also do this in order to avoid being labelled as 'distressed', which could lead to a run on its finances. Certainly, during the 2008 financial crisis, the difference between the lowest and the highest Libor bids (the spread) increased significantly evidence that this sort of behaviour might have been happening.

Are there any other signs of abuse?

A more sinister abuse of the Libor-setting process relates to its impact on investment banks' trading profits. Historically, investment banks have made big money trading bonds and derivative products, many of which are priced off Libor. That means that even a small move in Libor can cause the price of a security to change, and given the big, leveraged bets made by many traders, these small moves can make the difference between big profits or big losses.

So one of the main accusations being made against some banks is that they broke the rules in the Libor-setting process. Certain parts of banks have to be kept separate from each other (via internal systems known as Chinese Walls'). In the case of Libor, it would mean that a trader couldn't speak to the person in his own bank who submitted the data for the calculation of Libor. But there is a possibility that this actually happened at some banks: some traders are being investigated for trying to manipulate their bank's daily bids for Libor for their own benefit.

The search for a better interest rate

The BBA has announced a review of Libor, but has defended the rate, saying it has been a reliable benchmark for 26 years. But its credibility as a key financial rate has been damaged. The main issue for most people is trust, particularly given the huge levels of taxpayer support given to banks.

Nothing has been proven as yet, but if Libor has been manipulated for banks to make big profits (or avoid big losses) then it could open the floodgates for legal action, bad news for banks' already-battered balance sheets.

So what are the alternatives? One option, says FT Alphaville, is RONIA, or the repurchase overnight index average. This rate is based on the weighted average of secured loans actually transacted. In other words, it is based on the actual costs that banks pay rather than what they think they might pay, which seems far more sensible.