The London Interbank Offered Rate (Libor), which was introduced in 1984 by the British Bankers Association (BBA), provides a benchmark rate for inter-bank lending, and which is used to set other short-term rates.
Libor is based on a daily calculation of the average rate at which banks can borrow from each other in various currencies and for various maturities in the London interbank market. The increasing significance of the Libor rate reflects London’s growing importance as a global financial centre.
Since its creation, Libor has become the world’s most widely used reference rate of interest used in setting other rates across a range of financial markets. It was introduced to establish an average daily rate for interbank lending and bring uniformity to interest rate calculation on a range of instruments, including variable rate mortgages and futures contracts.
In essence, Libor is the rate at which the preferred and most creditworthy banks (the ‘prime’ banks) can borrow from each other if they need to. The rate for less preferred banks (‘sub-prime’ banks) will be higher than Libor, but still based on it. The rate clearly reflects the confidence that lenders have in borrowers, so at times of higher risk and lower trust the Libor rate will rise. Libor rates rose considerably in late 2007, reflecting the underlying concerns that banks had about the creditworthiness of other banks. Prior to the rate fixing scandal, Libor was widely seen as the main barometer of how global financial markets are reacting to changing conditions, and a leading indicator of where rates are likely to be in the future.
Once the daily rates are calculated by the BBA they are published at around 11 am by Thomson Reuters. The rate is an average of the contributing banks individual rates at which they would be prepared to lend, rather than the current rate at which they do lend – hence it provides an indication of the bank’s reactions to daily events. In short, it is based on individual banks assessments and opinions rather than reflecting real transactions. It is because of this that there is the potential for rate ‘fixing’, or deliberately providing misleading information so as to influence the setting and movement of rates.
Potential fixing was assumed to be impossible by using a process calling 'trimming'. The use of trimming should, in theory, factor out the possible effects of deliberate manipulation by one or a few banks. In this case, trimming meant excluding the top and bottom quartile (25%) of individual bank submissions – which in theory should eradicate undue manipulation. However, recent investigations have cast serious doubt about the effectiveness of trimming, and it now appears the case that the Libor rate had been manipulated to the benefit of some banks for the best part of a decade - perhaps going back to the late 1990s.
By submitting marginally lower rates than the ‘true’ rate, a bank can give the impression that it has more confidence than it really has. Lower submitted rates will falsely reduce concerns about creditworthiness and distort rational decision making, leading to significant information failure and increasingly inefficient financial markets. In addition, rates can be artificially manipulated to be higher or lower than the ‘true’ rate to allow traders to increase their profits on some contracts - again, causing markets to become inefficient. If a number of banks submit inaccurate rates, the whole market becomes distorted, and excess profits can be derived. Such manipulation now appears widespread.
Sure enough, last week Barclays was fined a whopping $450 m for submitting inaccurate rates between 2005 and 2009, and, with the scandal breaking and further investigations likely, Libor has, clearly, lost much of its credibility. Indeed, most observers now accept what seems to have been widely known in private for several years - that Libor is a dead duck. The current rate fixing scandal is yet further evidence of the ineffectiveness of banking regulation dating back to the wholesale deregulation of Big Bang.