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What is LIBOR

Libor
stands for the London Interbank offered rate. This is the interest which is
stated when one bank lends to another bank. The interbank market is “the market
where banks lend to each other in both domestic and international markets” (Arnold,
2012) It is not just the banks that are the lenders but it includes financial
institutions, commercial and industrial organisations. Therefore, the interbank
market exists so that any of these organisations including banks can place
money in the interbank market and earn interest on it. On the other hand, if a
bank or a financial institution needed to authorise a loan to a customer and it
did not have the funds to authorise the loan, the bank can therefore borrow
within the interbank market.
The interest rates are relatively low because the borrowers of the loans are
safe banks. This interest rate creates a benchmark which is what we call LIBOR.
LIBOR interest rates are calculated for 5 different currencies and 7 different maturities. The maturities are 24 hours, a week, a month, 2 months, 3 months, 6 months and 1 year. The 5 different currencies are American dollar, British pound, European Euro, Japanese yen and the Swiss franc. The interest rates are released everyday around 11:45 a.m. by ICE Benchmark Administration.
At the start of the 1980s there was a need for a benchmark for the financial organisations. Hence why LIBOR was created. It was needed to calculate the price of financial products such as options. The British bankers Association then undertook various steps on the creation of the first LIBOR rates which were released in 1986.  

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When the LIBOR rate in calculated, they are calculated by the British banking Association through Thomas
Reuters. They ask a panel of between 8 to 16 international and UK banks what rate they could borrow loans between all the different maturities available. Furthermore, the contributor bank is asked to base their LIBOR submission on the following question “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am London time?” (Theice.com, 2018)

 

The group of banks inform the BBA about which interest rate they expected to be able to raise a loan in the interbank market at that very moment for every maturity offered. The measurements will not be based on actual transactions. This is because each bank will not borrow a lot of money each day from the maturities offered. Once all the interest rates are taken from each of the banks, the lowest and highest 25% of the 8-16 values are eliminated. Within the remaining 50%, an average is calculated and this will therefore produce the official LIBOR rate. This is done for every maturity.

 

The Scandal

LIBOR
has different uses and purposes. It is used as the reference for short term
financial contracts such as futures and swaps. It is estimated that the value
of these contracts is up to/ over $300 trillion (Chailloux, Brousseau and Durre
2009) LIBOR is also used as an indicator of the current stability of financial
markets.
LIBOR relied heavily on the integrity of the banks to give the right
predictions. This combined with the success of this benchmark for the many
years it had been used for gave the panel of banks an incentive to manipulate
it.

The
financial crisis was first triggered in 2006 when house prices in the housing
market started to fall. With the revolution of dotcom and the 2001 recession, this
triggered collateral debt obligations from mortgages that had been purchased on
the secondary market. As the subprime mortgages were joint with the prime
mortgages, it made it very difficult for the investors to see any risks that
came with these products. As the CODs started to increase, the house prices
began to decrease and the subprime borrowers could not afford to pay back the
loans so in essence began to default on loans that were more than their homes.
When the CODs started to become worthless due to the vast debts it was causing,
investor tried to unload the CDOs but the problem was that there was no market
for them. This caused subprime lender failures which then worked its way up to
the banks. Due to this the investment banks Lehman Brothers and Bear Stearns
collapsed due to the amount of subprime debt they carried. Many banks began to
fail and many needed to be bailed out by the Government
(Anon, 2018)

The
financial crisis which was the worst since the great depression was a motive
for many of the panel banks to fix the LIBOR benchmark. The manipulation of
LIBOR was internal and external. The internal manipulation was when a trader in
the panel bank would request that the data submitted every day to the BBA would
either go up or down to then give them a better trading position when they are
executing their trades. The external
manipulation happened for traders from another bank. The requests were made
through email, verbally and even in writing. This was one motive to gain an
unfair advantage in the banks trading position was one of the two motives of
fixing the LIBOR rates. Furthermore, by lowering the LIBOR rates as done by the
panel banks, the interest costs would fall more than the interest revenues
which would then boost the profits of the banks.

The 2nd motive was due to the
financial crisis shown above. Due to the crisis, banks did not want to lend to
each other because they did not trust each other. Furthermore, the public began
to lose faith in the banks. For a bank to function they need deposits from the
public. These deposits are then used as loans and banks set higher interest
rates on the loans to gain a profit. As the public began to lose faith, many
people stopped depositing their money in banks and the banks feared that a bank run would occur. As banks feared this,
the panel banks began to change their LIBOR submissions by lowering the values
they gave to Thomas Reuters. This made them appear to be in a better position
than other banks than they are. If they reported the actual values, this could
cause more distrust from the public on the banks which could have caused bank
runs. In the beginning of 2012, LIBOR came under the spotlight because of the
submissions made by the panel banks during the financial crisis. Due to the
allegations that these panel banks had understated the actual values to show
that they were trustworthy and safe banks during uncertainty in the market, in
a formal investigation the banks UBS ($1.52 billion), RBS ($612 million),
Barclays and Rabobank ($1.07 billion) were all fined for the scandal. Further
to these settlements, the banks involved also had to pay a settlement of $453.6
million to financial authorities of the U.S and UK. (Hou, and Skeie. 2014)

 

The reforms

There are several reasons to why
LIBOR should be reformed. One of them is the fact that banks within the panel can
communicate and share their LIBOR quotes before they submit them to Thomas
Reuters. This is an incentive because although they won’t be the final quotes,
by sharing them with each other before they submit them, the banks will be able
to eliminate any risk involved and create very good trading opportunities.
Another reason why it should be reformed is that there was no evidence that the
quotes that were submitted by the panel banks were ever screened by the BBA to
look for any suspicious patterns. (Abrantes-Metz, 2012) Even after the LIBOR
scandal came to light, there hasn’t been a lot done to restore the confidence
within the markets and the banks.

Therefore, since the financial crisis, the reputation of
LIBOR has not been the best. There have been various reforms that have been put
forward to try to stop another manipulation scandal occurring between banks.
The first reform is called CLIBOR (Committed LIBOR). This reform is made up of
3 main foundations which are Commitment, Transparency, and
Governance.
Commitment

This requires that all the banks within the panel to submit
bid and ask quotes for the lending within the interbank market. Any lending that
occurs after the banks submit their LIBOR quotes, must be at a rate that is no
higher than the submitted ask quote and it can’t be lower than the submitted
bid quote. There would also be a penalty that is given to any bank that
executes a loan for example that is above or below the submitted bid and ask
price.

Transaction-
based(Transparency)

There is transparency because the panel banks are required to
submit their interbank lending and borrowing transactions to a data- cleaning
house. This would be a big benefit because it would create a lot of reliable
transaction based data within the banks. This means that the banks would not be
able to alter the submitted LIBOR quotes as they are only using their actual
lending and borrowing transaction data.

Independent Governance

It is vital to have a governing body for this reform. This is
because the governance body would oversee the lending rate and reporting the
transactions of banks and other financial institutions.

The governing body would select an organisation that would oversee
the data clearing house. The organisation would then publish the interbank
interest rates for all the available maturities and make sure that every bank
in the panel has the right transaction data submitted for its ask and bid
quotes, they would give penalties to any bank not following this and
furthermore they would develop a highly technical algorithm that calculates the
CLIBOR rate that would reduce the risk of abuse of system such as seen in the
LIBOR scandal.

 

The CLIBOR rate would be a very successful reform. This
is because it would produce a borrowing rate that is a lot more accurate than
LIBOR. This is because they base their rates from the actual transactions
submitted by the banks. This means that it makes it very difficult for the
banks to alter the submitted rates as it is based on real data. Furthermore, if
a bank did alter the figures, they would be given a fine. So, this in turn
would reduce the incentives of banks finding trading opportunities by
manipulating the rate (Abrantes-Metz and Evans 2012). The only downfall for this reform
is that it would cost more than the current LIBOR benchmark. But this should
not be a problem because during the LIBOR scandal, banks made millions of
profits out of greed, so having a reform that will cost more for the fairness
within the market and stop manipulation is a reform that will be worth it.

Coulter and Shapiro in their working paper “A mechanism for
LIBOR” (Coulter and Shapiro 2013) attempted to transform LIBOR completely. The method
was also that the bank submissions for the rates would be based on their
transactions. If there were no data regarding the banks borrowing activities,
then any suspect submissions would be called into action by other panel banks.

 

Furthermore, another possible approach is changing
LIBOR into a flexible trade-weighted one (Brousseau, Chailloux, Durré 2013). In
this, the rates submitted would show the banks wholesale funding cost which
would also be based on the actual transactions of the bank. For it to be a
reliable rate, the successor to LIBOR should have the characteristics which
are: robustness, reliability, availability, frequency and representativeness. (Bank
of international settlements 2013).

After the scandal, the British
banking association let the Intercontinental exchange (ICE) oversee the
functions of LIBOR. According to Philip Stafford in a Financial Times papers
The ICE have plans to reform LIBOR. They would introduce a standard formula for
all the banks to use for their LIBOR submissions. Due to the nature of depth of
the scandal, the ICE want a new system that not only will use data from bank
transactions but also data from around the world as a basis for the
submissions. This is due to the fact that 20 banks that are within the panel
that submit the benchmark have developed their own ways and methods of
producing their LIBOR rate. This proposal would be a success because it would
mean that every bank would use the same formula. This would reduce the risk of
manipulation because there will be external data used on top of the bank
transaction data used. But on the other hand, many believe the reforms will
hurt the financial industry. Joel Shapiro and Peter Zimmerman argued that this
decision would only eliminate the manipulation but it would also make
manipulation less detectable. (Harry Wilson, 2018) this in turn would make the
banks more profitable.

To conclude, the LIBOR scandal still
showed a lot of problems within the financial industry and with LIBOR. With
these reforms in place, it will be difficult to find a successor that can be
implemented in a reliable manner and not cause any controversy. A new benchmark
administered by the bank of England called the Sterling Overnight Index Average
(SONIA) has been voted by banks to take over LIBOR in 2022. This is the first
step during this long journey of reforming LIBOR. Some fear that it won’t be as
reliable and transparent due to the fact that there has been evidence that the
Bank of England was also behind the rigging of LIBOR. A report by the BBC shows
a telephone recording between the Barclays former boss Bob Diamond and his boss
Mr Dearlove saying “The fact of the matter is we’ve got the
Bank of England, all sorts of people involved in the whole thing… I am as
reluctant as you are… these guys have just turned around and said just do it
(BBC News, 2018). In all, replacing LIBOR is the first step but the hardest
step is making sure there is transparency between the banks and financial
institutions.