As a part of my short and quick understanding of financial crisis and scandals that has rocked the nations across the globe, today I’ve taken up the LIBOR scandal. Although there’s a debate if it’s a scam/scandal or not, we must know what actually happened and be aware of any such incidents in the future and how it affects us directly or indirectly.
This incident has been in the news for quite some time and it seems it has died a natural death but being students of finance we must be in a position to properly analyze the case as most of us would work in financial services sector and banks are integral part of it.
So before I begin, we must have a thorough understanding of what is LIBOR.
LIBOR stands for London Interbank Borrowing Rate. It is used as a benchmark to set payments on about $800 trillion-worth of financial instruments around the globe. Three-month dollar LIBOR, is supposed to indicate what a bank would pay to borrow dollars for three months from other banks at 11am on the day it is set. The dollar rate is fixed each day by taking estimates from a panel, currently comprising 18 banks, of what they think they would have to pay to borrow if they needed money. The top four and bottom four estimates are then discarded, and LIBOR is the average of those left. The submissions of all the participants are published, along with each day's LIBOR fix.
When the news about Barclays, a 300-year-old British bank, rigging an obscure number started to surface, players from the financial sectors began hue and cry.
In settlements with the Financial Services Authority (FSA) in Britain and America's Department of Justice, Barclays accepted that its traders had manipulated rates on hundreds of occasions. Bob Diamond, its chief executive, who resigned on July 3rd as a result of the scandal , retorted in a memo to staff that “on the majority of days, no requests were made at all” to manipulate the rate. This was rather like an adulterer saying that he was faithful on most days.
Whether Bob instructed Barclays to lower its submissions or not, regulators had a pretty clear motive for wanting lower LIBOR: British banks, in effect, were being shut out of the markets. The two hardest-hit banks, RBS and HBOS, were both far too big to fail, and higher LIBOR rates would have made the regulators' job of supporting them more difficult.
So where is the flaw?
o LIBOR is based on banks' estimates, rather than the actual prices at which banks have lent to or borrowed from one another
o Transparency issues
o Incentives to lie
What would possibly happen if it is proved that Banks were at fault?
It is actually very difficult to quantify the loss as there is an asymmetric risk -For each of the bank’s clients who may have lost out if LIBOR was manipulated, another will probably have gained. Yet banks will be sued only by those who have lost, and banks will be unable to claim back the unjust gains made by some of their other customers.
But what can be the possible solution to rectify the flaw?
The first step in rectifying the flaw is to identify the loop holes and plug in the gaps. Complex laws can never replace common sense. Hence one of the first thing that needs to be possibly done is:
o Base the rate on actual lending data rather than just the estimates
o Raise the number of banks in the panel
Although theoretical changes needed to repair LIBOR are not difficult, but there are practical challenges to reform and one of the biggest challenge is the lack of will power from the banks as well as regulatory bodies. In the rush to make more money and greed to be the most powerful, these organizations have some where forgotten the real objective of their existence-Serve the customer in the best of their interests. However it seems every one has taken the phrase “morale to his own “ quite seriously.
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