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Libor scandal and its implication

samir lodha 
on 03 September 2012

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How is the Libor setting done -

BBA Libor is in use since 1986. Currently its calculated by Thomson Reuters on behalf of British Bankers Association (BBA). Libor is calculated for 10 different currencies and for 15 different maturities starting from overnight to 1 year. To set USD Libor, 18 banks submits their rate at 11:00 AM London time. Top 4 and bottom 4 are taken out and the average of the remaining 10 rates equals to Libor. Please note from the definition provided in the box, which Banks are supposed to provide their perception about the rate at which they can borrow.

Libor is used for loans, investments and financial instruments and derivatives for trillions of USD with estimates varying from USD 350 trillion to USD 800 trillion.

Key points to be noted are:

1. The rate submitted by a Bank is banks perception of its cost of unsecured funds in the London interbank market.

2. BBA has lots of leeway and discretion in setting the Libor specifically In the event that it is not possible to conduct the bbalibor calculation in the usual way, the BBA - in consultation with contributor banks, the bbalibor Steering Group and other market practitioners - will use its best efforts to arrange the setting of a substitute rate. This will be the bbalibor calculation for the currency, maturity and date in question. Such substitute measures will be communicated to the market in a timely fashion

The Issue

Over a period of Libor was manipulated by multiple banks including Barclays. The manipulation effects are different for pre-crisis period and during crisis period. In the pre-crisis period it was a few bps higher or lower depending on the banks derivative and rollover positions. So the net effects are unclear.

During the crisis period the whole markets were trying to figure out which banks are borrowing at a higher rate to ascertain who is in trouble. So a higher rate submission means that the bank is in trouble and that would start a semi run on the banks including plummeting equity and increasing CDS. It is in this period that few banks colluded to keep Libor artificially low clearly diverging from the actual cost of borrowing reflected by Credit Default Swaps market OIS swaps.

Barclays has been fined already by authorities and other banks are under probe and are likely to be fined.

The Impact

Parties involved in Libor linked financial instruments are Numerous Banks, Investors, Hedge Funds, Pension funds, Borrowers globally, Mortgage borrowers in US etc. Please note large corporates in US mostly borrow loans linked US prime rate.

Generally speaking a lower libor hurts banks as lenders, benefits borrowers and hence its against banks interest to keep Libor low. However during the crisis, Libor levels and submitted rates became more of a signal to the market. A bank submitting higher Libor rate was considered the one in trouble by the market. At that time irrespective of gains/ losses on the lending, a number of submitting banks had interest in submitting a lower rate and keeping the libor low.

Please note following key points regarding impact of the scandal:

1. During crisis period investors and lenders lost money for libor being artificially low and borrower saved money.

2. In pre-crisis period, its difficult to judge who gained and who lost since Libor fixing could be higher or lower than fair levels. Calculating fair level itself is a very difficult task.

3. If one bank underreported by 20 bps we first have to see whether the banks submission was included or excluded. If included then since final rate is average of 10 banks, such wrong submission would have had only 2 basis point impact on Libor. However the equation changes if multiple banks colluded and submitted Libor in such a way that they get included and in that case average effect could be higher.

Likely Lawsuits

Investors and small banks who have lost money will and are planning to file suits saying they have lost money during crisis period because of artificially low libor. Money market funds like Vanguard, Blackrock, and Fidelity will be filing legal suits against banks. The challenges in lawsuits are as follows -

1. You cannot file suit against a single bank since logically a bank submitting wrong rate will not be included in the calculation. Hence suit has to be filed against multiple banks and the banks also can claim that they have also lost money.

2. Even if bank is proven guilty of manipulation, they have mostly not gained directly and hence who will make good the damages as claimed by the investors

3. Borrowers will claim innocence saying we have paid as per fixing.

4. Banks like Barclays will say, We have not gained because of the wrong fixing. Also they will say it was a mistake by a trader and in anyways its difficult to prove since BBA asked for perception.

5. Because of the complex methodology its difficult to quantify damages suffered by an investor as that process would involve assessing correct submission of all the 18 banks and then finding the correct Libor and its impact

However small banks, money market funds and investors like City of Baltimore are already on their way to file legal cases. If Banks are asked to make good the losses then that would be chaotic for the financial sector. The litigation process can be expected to continue for a while.

The alternatives

After the scandal Libor is under attack -

The idea that one can base the future calculation of Libor on the idea that my word is my Libor is now dead, It will have to be based in the future, in my judgment, on actual transactions in order to bring back credibility to the system. - Bank of England Governor Mervyn King said while presenting central banks Financial Stability Report.

The possible alternatives are as follows:

NO.

Alternative

Details

1

Continue with Libor with some modification

Libor may continue to be set by BBA with increased scrutiny and closer link with actual trades wherever possible. CFTCs recommendation while penalising Barclays says that Banks should:

1) Try using actual trade data to the extent possible

2) Cut communication between derivative trader and rate setter

3) There will be closer audit and scrutiny of the process.

There will be attempt to link the Libor rates to actual traded rates. Problem with actual traded rate is that the market is almost frozen and traded volumes are in few billions only.

Likely modification in Libor will be to make it closer to the traded rates and that should take Libor higher considering the state of interbank credit market.

Another problem is if banks may start to avoid participating in the polling to avoid litigations and penalties.

US Treasury Yield

More investors may shift to fixed rate lending or lending linked to US Treasury rates.

Actual trade based benchmark like - GCF Repo Index or

Some other index in line with Australias BBSW kind of fixing.

GCF repo fix is the rate index based on actual repo trades and has been recently started. Problem is its secured lending and may not reflect banks actual cost of borrowing.

Second problem with this system is when market becomes defunct and actual trades not happening then how you set the rates.

We believe most likely Libor will continue to be set by BBA with greater scrutiny to avoid manipulation and closer ties with actual traded rates. With the unstable outlook for few years for banking industry, We would predict actual traded rates will be moderately higher. In periods of financial crisis the rate will shoot up since banks will not lend to other banks doubting their creditworthiness.

However we need to monitor the developments to see whether there will be renegotiations on the interest rate swaps in case Libor setting tends higher.

The other key points for Indian corporates are:

1. Will the lenders claim extra interest saying Libor fixing was wrong In our opinion thats unlikely and remote

2. Will the IRS hedge providers renegotiate for a higher rate or back out from existing IRS contracts The possibilities of such an event are low but not impossible. For a clearer answer we need monitor the developments around Libor including views of ISDA, BIS, BOE, FED etc. on the issues and also how the Litigations proceed.




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