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The London Interbank Offered Rate, better known as LIBOR, is being phased out over the next five years. Created in 1986 by the clubby London banking community to set rates on large bank loans, LIBOR quickly became a benchmark interest rate in global finance.
Each day, each bank from a group of leading banks around the world submits the interest rate it would be willing to lend to other banks. The average of those rates becomes LIBOR.
By some estimates, there are more than $350 trillion of outstanding derivatives, loans and mortgages linked to LIBOR. There are $1.3 trillion in adjustable rate mortgages tied to LIBOR. Other rates that price off LIBOR are credit cards and student loans. Author David Enrich calls LIBOR “the world’s most important number.”
Critics have argued that the inexact methods for calculating the rate and the lack of regulatory supervision invited the opportunity to manipulate the number. Small changes in the level of LIBOR had significant effects on the profitability of large banks’ loan portfolios. This sowed the seeds of the LIBOR scandal.
As greed overcame morality, the LIBOR manipulation began, with traders asking the employees who submitted their banks’ daily rates to provide figures that would make their holdings more profitable. From 2005 to 2009, it was discovered that traders made 257 requests to fix the rate. The rate-rigging expanded as traders colluded with colleagues at other banks to alter their rates, too.
UBS trader Tom Hayes became the first person convicted for rigging LIBOR. Hayes booked hundreds of millions in profit over three years. He was arrested in 2012 and ultimately sentenced to 14 years in prison. Next, Barclays admitted to misconduct in manipulating rates, costing Barclay’s Chairman Bob Diamond his job. More than 100 traders and brokers were fired or suspended, and 20 people were criminally charged.
Barclays, JP Morgan, UBS, Royal Bank of Scotland and Deutsche Bank all have been fined by regulators for manipulation of LIBOR. Deutsche Bank has paid $3.5 billion in fines, more than twice the amount of any other institution. So far, lenders around the world have paid $9 billion in penalties.
The LIBOR scandal hastened the need for a more trustworthy interest-rate benchmark. As UK regulators are preparing to pull the plug on LIBOR, the search is on for a replacement. Some say five years is not long enough for banks to overhaul their systems and unwind their reliance on LIBOR.
In June, a group of banks voted on a new rate derived from a broad set of borrowing transactions, secured by U.S. Treasuries, known as repurchase agreements or “repos.” This rate would begin to be voluntarily phased in next year. One flaw seen with the method is that the repo rate includes trades between banks and buy-side firms and no longer will be a reflection of interbank lending, or bank credit strength.
Market participants acknowledge it won’t be easy to transform the financial industry’s interest-rate pricing structure away from the deeply imbedded LIBOR. They emphasize there must be a plan to encourage the market to adopt the new rate, which ultimately will become a benchmark throughout global financial markets.•
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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 317-818-7827 or ken@aldebarancapital.com.
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