First thing’s first. What is LIBOR?
The London Interbank Offered Rate (LIBOR) is simply the interest rate at which banks pay to borrow money from each other. The British Bankers’ Association computes LIBOR on a daily basis by averaging the interest rates submitted by the 16 international member banks.
What’s important to know about LIBOR is that it’s widely used as a benchmark for determining the interest rates of other securities and loans. Since LIBOR is basically a reflection of the big banks’ confidence to lend to each other, it makes sense to use it as a benchmark for other assets.
For example, a company with a relatively good credit rating could borrow money at an interest rate of LIBOR plus five or six points. Today it is estimated that around $360 trillion worth of mutual funds, currencies, swaps, pensions, and other financial products are affected by LIBOR.
Investors around the world were outraged when the LIBOR scandal broke out in July. If you recall, Barclays was accused (and was eventually charged) of purposefully posting low LIBOR quotes from late 2007 to mid-2009 to accommodate their own interests.
You’re probably asking why Barclays did this. Well, Barclays tried to control LIBOR for two reasons. The first one is obvious and the other one isn’t as obvious. Can you guess what they are?
I’ll give you a few moments to mull it over.
LIBOR was artificially pushed lower for more profits. The idea was that a bank’s LIBOR-submitting department would base its rates on what the trading department wanted. This would enable traders to know the rates ahead of time and make money whether it goes up or down.
The second reason is to make them appear creditworthy and healthy. By submitting a low rate, they are implying that investing in the bank is very safe, and that you should put trust your money with them.
While the major banks manipulated LIBOR for their own benefit, many people suffered. Investments vehicles based on LIBOR received less return as banks weren’t paying the correct interest rate.
Proposed LIBOR Changes
LIBOR setting is obviously flawed. That being said, Martin Wheatley, chief executive-designate of the Financial Conduct Authority, has proposed a plan for reforming LIBOR. I’ve outlined the main points below:
- Do away with the BBA and create a new and independent body
- Create a code of conduct for the rate submitters
- Implement tougher systems and controls the rate submitters
- Subject the LIBOR-setting to regular external audit
- Harder punishment for those who manipulate and do not adhere to the rules
- Encourage other relevant banks who do not submit rates to also participate
For now, how the proposed changes will affect the market still remains to be seen. We’ll just have to wait and see how things unfold in the next couple of weeks.