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Understanding the LIBOR Scandal

by | July 9th, 2012 | 02:29 pm
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The Barclays scandal over manipulation of the LIBOR (an acronym which stands for London InterBank Offered Rate) has put this important monetary indicator in the spotlight in recent days. The LIBOR rate may not be well known to people outside the financial sector, but it affects most people’s lives directly or indirectly, underpinning hundreds of trillions of dollars in transactions across the globe. It represents the primary benchmark index for pricing a large variety of consumer and corporate loans, debt instruments, and debt securities. It also represents the reference indicator for settlement of interest rate contracts on many of the world’s major futures and options exchanges. It is mentioned in standard derivative and loan documentation, and is used for an increasing range of such retail products as mortgages and college loans. More broadly it can also be viewed as an indicator of banking conditions, and of market expectations for central banks’ monetary stance. Following the Barclays revelations, it is therefore imperative that a review be undertaken aimed at fixing the mechanism of LIBOR and protecting it from manipulation. A thorough study of regulatory issues associated with LIBOR is also important to prevent future failures in the regulatory supervision of wholesale conduct.

LIBOR is basically an indicative average interest rate at which a sample of major banks (the so-called panel banks) agree to lend each other unsecured funds on the London money market. Accordingly, it represents the lowest real-world cost of unsecured funding in the London market.

LIBOR is not a single rate. Indeed, there are no fewer than 15 different maturities (ranging from overnight to 12 months) and 10 different currencies for which it is calculated; 150 rates are therefore calculated each business day. The official LIBOR interest rates are daily announced at 11:00 a.m. GMT by Thomson Reuters on behalf of the British Bankers’ Association (BBA, see www.bbalibor.com).

Just before 11:00 a.m. GMT, the BBA polls a specific panel of highly reputable, high-volume banks that participate in the London wholesale money market. The BBA finds out the rate at which each bank on the panel could borrow from other banks, for specific maturities and currencies. The BBA estimates the central tendency—the so-called interquartile mean—for each maturity, and then publishes these rates at about 11:30 a.m. GMT.

To understand the mechanism underlying the LIBOR calculation, it is helpful to remember that every contributor bank is asked to base its submissions 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?” Submissions are therefore based on the lowest rate at which a bank expects to be able to borrow from the London interbank money market for a given maturity and currency. LIBOR therefore is supposed to reflect a perception by banks of their credit and liquidity risk profile, which then helps to determine whether they will be able to construct a curve to predict accurately the correct rate for different currencies and maturities. Quite interestingly, the term “reasonable market size” is intentionally left broadly defined because the concept is intrinsically subject to changes and variations in different currencies and maturities.

Once Thomson Reuters has collected the rates from all panel banks, the highest and lowest 25 percent of value are eliminated. An average is calculated of the 50 percent remaining “mid-values” in order to obtain the official LIBOR (BBALIBOR) rate.

The establishment of LIBOR 26 years ago was a response to the need by banks for a measure of uniformity in the market and a benchmark or reference for the new instruments being traded with increasing frequency in the London interbank market at the beginning of the 1980s. It was felt that the use of a standard rate would facilitate the operation of markets and make benchmarking more transparent and objective. Following the joint designing effort of BBA and a number of other working parties, including the Bank of England, the use of LIBOR started in January 1986 for three currencies: the US dollar, the Japanese yen, and the UK sterling. Since then the LIBOR has become the most important reference indicator for financial transactions and is today used to set the interest rates on more than $350 trillion worth of various financial instruments.

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