LIBOR Manipulation - Why Does It Matter?
To date, some $2.5billion has been levied in fines on just 3 banks and it’s likely that more will follow. Why does it actually matter if banks have manipulated LIBOR, especially if it results in lower interest rates?
Firstly, what is LIBOR? LIBOR stands for
the London Interbank Offered Rate and is set every working day to indicate rates
of interest payable over various periods of time in various currencies. It is used as a “benchmark” for
setting borrowing rates to borrowers (individuals, companies, governments,
other banks).
LIBOR is calculated by the
British Bankers Association through Thomson Reuters as their agent. A number of “contributor banks” are used (16
are used for Pound Sterling LIBOR). Every
contributor is asked to base their submission on the following question: “At what rate could you borrow funds, were
you to do so by asking for and then accepting inter-bank offers in a reasonable
market size just prior to 11 am?”
So, submissions
are based upon the lowest rate at
which a bank thinks that it could go
into the London interbank money market and obtain
funding for a period of time in a given currency.
Once every bank
has submitted its estimate, all estimates are ranked from highest to lowest,
and the top and bottom 25% are eliminated.
The remaining estimates are then averaged to produce an indication rate.
If all
contributors “lowball” their estimates, then the average rate must necessarily
be lower than it otherwise would be.
Why should a
contributor “lowball” their estimate?
The two main reasons that I can see are:
·
They don’t want to people to think that they are in
difficulty by submitting higher (honest) rates, which then means they would pay
more to borrow;
·
Various financial products are based on LIBOR and
contributors can make artificial profits by “forcing” LIBOR down.
One
particular product is the “Interest Rate Swap” or “IRS”. This is used by borrowers to protect themselves against adverse movements in exchange
rates. For example, if rates are low,
you want to protect yourself from a rise.
If they are high, you want to take advantage of any fall. To do this, you would take out an IRS with
your bank.
Suppose
Company A wants to protect itself against a rise in interest rates. The company go to their bank and make a deal
whereby, if LIBOR rates rose above a certain level, the bank would pay them the
difference between the new rate and the level agreed. If rates stayed below a certain level,
Company A would pay the difference to the bank.
In this case, they’re swapping “floating for fixed”.
If Company A
is borrowing at high rates but thinks that rates will fall, they would want to
take advantage of any fall and so would arrange with the bank that if rates
fell below a certain level, the bank would pay them the difference between the
lower rate and the actual rate they’re paying.
In this case, they’re swapping “fixed for floating”.
So, it’s in
the banks’ interests to pay out as little as possible (or receive as much as
possible). Where LIBOR rates are
artificially low and banks have customers who have swapped “floating for
fixed”, they want to make sure that they don’t have to pay them. At the moment, I suspect that most customers
will swap “floating for fixed” as interest rates are at an all-time low and the
only way that they can really go is up.
Banks want to avoid this.
Some banks
have been accused of selling IRSs as part of a deal to customers and/or to
customers who lack the sophistication to understand the risks of them, hence
the mis-selling accusations that are now flying around.
The point
is, manipulating rates for personal financial gain is unethical and results in
potential losses for customers. Imposing
a product that takes advantage of manipulated rates on customers is
unethical. A bank has a duty to look out
for the best interests of its customers, and this may not be happening.
I have spent more than half my life delivering change in different world markets from the most developed to “emerging” economies. With more than 20 years in the world financial services industry running different service, operations and lending businesses, I started my own Performance Management Consultancy and work with individuals, small businesses, charities, quoted companies and academic institutions across the world. An international speaker, trainer, author and fund-raiser, I can be contacted by email . My website provides a full picture of my portfolio of services. For strategic questions that you should be asking yourself, follow me at @wkm610.
Labels: Customer Care, Financial, Regulation, Risk, Selling
posted by William Martin @ 10:38
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