The LIBOR Fix, Part Two

By Satyajit Das  JUL 24, 2012 10:00 AM

What exactly is the fix?


Editor's Note: This article is the first part of a two-part series.  Click here to read The LIBOR Fix, Part One.

The Long Fix

Lord Turner, the head of UK FSA, told a UK parliamentary committee that it hadn’t occurred to him before 2009 that the rate was something that could be manipulated. However, anecdotal evidence suggests that LIBOR submissions may have been manipulated over a long period. Banks and regulators may have been aware of these practices for some time, but did not take corrective action.

Barclays’ (BCS) senior management and board of directors have indicated that they became aware of the problem recently. Banks offer the same excuse as JPMorgan (JPM) in 1933: “Since we have not more power of knowing the future than any other men, we have made many mistakes (who has not during the past five years?), but our mistakes have been errors of judgment and not of principle.”

Between 2007 and 2008, it appears that Barclays’ compliance department did not act on three separate internal warnings about conflicts of interest and “patently false” rate submissions. In an opinion piece published in UK’s Independent on July 7, a former Barclays' employee alleged that problems with LIBOR fixings were escalated by several people up to their directors and further within the organization.

Recent disclosures indicate that UK and US regulators knew that banks were posting artificial rates that did not correspond to the actual rates that the banks would pay to borrow. In April 2008, a Barclays’ employee notified the Federal Reserve Bank of New York (also known as the New York Fed) that the bank was underestimating its borrowing costs. A transcript of the telephone call is revealing: “….[W]e know that we're not posting, um, an honest LIBOR … we are doing it because, um, if we didn't do it ... it draws, um, unwanted attention on ourselves.”

On June 1, 2008, Timothy Geithner, then head of the New York Fed, emailed Mervyn King, Governor of the BoE, urging changes in the way the LIBOR is calculated. Internal New York Fed reports reveal concern about possible misreporting of LIBOR. None of these concerns were made public or steps taken to address the problem. Regulators, it seems, feared that the truth would destabilize already panicked markets.


Large banks are too big to fail ("TBTF"), a concept now codified in bank regulations. It remains to be seen whether large banks and their employees are too big to jail ("TBTJ").

Authorities have settled cases of LIBOR manipulation, perhaps driven by a desire to avoid creating a banking panic in an environment where financial institutions are vulnerable.

The UK FSA case was based on breaches of various parts of its Principles for Businesses code, specifically Principle 5, which requires a firm must observe proper standards of market conduct.  The US Department of Justice (“DoJ”) cited violations and misconducts, without specifying offenses.

The actions prima facie constitute manipulation and fraud, violating applicable securities laws. It may also breach antitrust and criminal law.  Evidence released shows possible criminal intent. Emails indicate awareness of the illegality with phrases used such as: “Don’t talk about it too much,” “Don’t make any noise about it, please,” and “This can backfire against us.” Individual traders and the bank that  is responsible for its employees’ actions would be liable.

Facing media attention and public fury, US and UK authorities are belatedly exploring possible criminal charges.

Big Fix

Responsibilities for the oversight of the LIBOR setting process are unclear.

The BBA insists that its process is transparent and unambiguous. As all contributing banks are regulated, the BBA argues that regulators are responsible for the behavior of individual banks.  The BBA knows each person responsible for submitting information and can demand to see the actual trades on which these figures are based. No evidence that this was done has been disclosed.

The UK FSA does not have a specific regime governing LIBOR submissions; instead, the organization relies on broad rules governing identification and prevention of conflicts of interest.

Increased oversight and regulation of the rate setting mechanism is proposed. 

Proponents of “narrow” banking argue that the separation of commercial and investment banking would solve the problem. But interest rate benchmarks affect normal lending and deposit taking activity as well trading activity. Proponents of the Volcker Rule argue that preventing proprietary trading by banks would minimize the problem. In reality, manipulation was not only related to trading positions but general banking activity.

UK regulators seem resistant to more stringent regulations. BoE Governor Mervyn King noted: “The idea that one can base the future calculation of LIBOR on the idea that ‘my word is my LIBOR’ is now dead.” But the Governor cautioned: “I think it’s very important that people don’t expect too much from regulation.”

UK authorities nostalgically hanker for an anachronistic time when most bankers in London were located in the Square Mile of the City and relied on mutual trust. According to folklore, nothing more than a central bank governor’s raised eyebrows was necessary to prevent unsatisfactory conduct. The good old days were not what they seemed: In the 1980s, the head of a UK merchant bank told new employees that he didn’t know how they would get rich given that insider trading was being banned.

A battle between major financial centers underlies the regulatory debate. In the 2000s, London became the world’s dominant finance hub. Non-intrusive, market responsive “light touch” regulation was a factor in its success. Damage to London’s reputation and stricter regulation would allow New York and European centers to regain competitive ground. US authorities hinted that they forced reluctant UK regulators to act and are at the forefront of driving reform. European Union banking and antitrust regulators have launched major investigations that may affect London’s competitive advantage.

Fixing the Fix

Amusingly, a recent BBA review proposed no changes to the rate setting methodology; instead, it merely proposed a code of conduct and greater scrutiny of LIBOR’s correlation with other financial data over time. A “shocked” BBA is now reviewing the process.

Given the large volume of transactions linked to the benchmark, it is essential that changes do not disrupt the operation of the market. Changes that affect legacy contracts may create significant legal problems.

There is agreement that the rates should be based on actual transactions rather than theoretical estimates. There should be independent oversight of the process. Banks should be required to segregate the function for fixing rates from other activity to prevent conflicts of interest. Rate submissions should be documented to provide transparency and an adequate audit trail.

The approach specified by the US Commodity Futures Trading Commission ("CFTC") in its enforcement order imposed on Barclays embraces most of these principles.

But the changes pose different problems.

While basing LIBOR on actual transactions is desirable, the theoretical benefits may be difficult to achieve in practice due to the shrinking size of the market and reduced activity levels. As Sean Keane, a former head of Money Market Trading at Credit Suisse, wryly observed: “…[O]ver the last four years there have been fewer actual transactions in the unsecured cash market than there have been discussions about how to reform LIBOR.” Where trading is disrupted as it was in 2007 and 2008, it is unclear how an accurate submission can be determined.

As differences in bank credit ratings and quality increases result in greater variations in borrowing costs, LIBOR rates will become variable and less meaningful. Instruments suggested by the CFTC to calibrate submissions in the absence of money market transactions ignore the creditworthiness of the bank. These include OIS, futures contracts and collateralized currency transactions or repos.

Membership of a LIBOR fixing panel, once considered prestigious, may no longer be attractive. Constant regulatory and public scrutiny as well as risk of criminal and civil prosecution outweighs benefits.  If banks become reluctant to participate in the process, then the importance and acceptance of the benchmark will decrease.

For loans and deposits, banks may move to internal rates, which reflect their cost of borrowing. The biggest effect will be on derivatives transactions.

Created in simpler times, LIBOR was designed for pricing loans and deposits. Over time, derivatives based on LIBOR have become dominant. Perversely, the cash market on which LIBOR is based now supports a vastly larger derivatives market. Curiously, generations of quantitative experts have built elegant models based on advanced mathematical techniques to price complex derivative instruments on a deeply flawed and easily manipulated base.

Christoph Rieger, Head of Fixed Income Strategy at Germany’s Commerzbank, told a reporter: “LIBOR is not a market interest rate. The spot fixings are at best bank guesses of a hypothetical interbank borrowing rate. For that reason, this will always be subject to controversy.” Given this fact, a UK member of parliament, Steve Baker, asked the obvious question: “Members are increasingly wondering how such a large industry has been allowed to grow up on such a finger-in-the-wind number.”

In the Fix

Barclays faces further prosecutions, including possible criminal charges. Other banks are under investigation. Civil suits, including class actions brought on behalf of affected parties, are likely.

Investment bank Morgan Stanley estimates that losses to banks could total up to US$22 billion in regulatory penalties and damages to investors and counterparties, equivalent to around 4%-13% of banks’ 2012 earnings per share and 0.5% of book value. In reality, it is difficult to accurately quantify potential losses.

Other rates and prices set by banks will come under scrutiny. The US DoJ is prosecuting US energy trading companies for allegedly submitting false trade data to Platts and other publishers of price indices used to price and settle natural gas transactions.

There is now significant uncertainty about potential litigation and unquantifiable losses faced by banks. Already facing weak earnings, asset quality problems, higher funding costs, and increased regulations, banks are likely to remain under severe pressure.

Fixing Banality

Described by Lord Mandelson as “the unacceptable face of banking,” Mr. Diamond is an ideal villain. The fall of a brash American not noted for humility provides a suitable narrative arc. His statement to the UK House of Commons Treasury Committee that the “period of remorse and apology for banks... needs to be over” now smacks of hubris.

Betrayal and fractured friendships are evident. Mr. Del Missier, one of Mr. Diamond’s trusted lieutenants, insists that he acted on instructions from his CEO sanctioned by the BoE in ordering staff to submit false rates.  Deputy Governor Paul Tucker and FSA Head Lord Turner are using the occasion to avoid collateral damage and burnish reputations in their rivalry for the high office of BoE governor. Suggestions of senior government officials and ministerial involvement add political intrigue. The contest between great nations seeking to dominate global finance provides a suitable background.

But the LIBOR fix may be a simple example of “beezle.” Coined by Economist John Kenneth Galbraith, the term describes the fraud or embezzlement that occurs in booms as sharp people take advantage of the favorable conditions and abundance of money.

Like the mis-selling of complex products and the inability to manage risk, the manipulation of LIBOR reemphasizes the deep-seated problems of large banks and global finance. A review of the role of finance in modern economies and societies is overdue. Unfortunately, recent history suggests the political will for the necessary corrective actions may not be present.

But like Al Capone who was ultimately convicted of tax offenses, banks may yet find that the LIBOR fix forces significant changes to banking regulation and practice. In an age of super computers and complex financial instruments, it would be a delicious irony if banks were to be undone by something as banal as an ancient rate setting process.
No positions in stocks mentioned.

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