London Interbank Borrowing Rate or LIBOR is one of the most fundamental tools that used in finance today making up the basic building block when it comes to deciding the prices and structures of more complex and complicated financial products used nowadays. From the most basic vanilla swaps to the tranche based Collateralized Debt Obligations (CDO) and Collateralized Mortgage Based Securities (CMBS) that have been created by the finance alchemist of modern times, everything is built on the basic pillar of LIBOR. CDOs and Credit Default Swaps (CDS), the main reason that created the crisis of 2008, were also indexed or on the arbitrary LIBOR rate. The basic use of this rate is to allow banks to use a benchmark against which they can decide the spreads they earn on the deposit and borrowing they carry out. By using this, the banks decide how much excess they can lend and then borrow from other banks when there is a deficit in their own accounts.
The rate is set by the British Bankers Association after a survey is carried out and it is calculated for every currency based on the costs that are involved. The rate is usually decided by asking different key banks at different times of the day and then deciding on an average. The recent manipulation that has been uncovered becomes more and more blatant and cause of concern when all these factors are considered. In addition to that, LIBOR is used by Europe and US so any foul play in the rate is seen as a threat to the transparency of the financial markets and the workings of the markets themselves. The actions and rage that is seen in the public sphere right now is proportional and substantiated based on this reason.
The British government has ordered an independent review to see how banks have been distorting the true picture that should have existed. The investigation, beginning in the next week, will look past the façade that certain banks have created. The scandal came to the fore front when Barclays, one of the biggest banks in UK, was found guilty of carrying out this practice on a widespread scale throughout the organization. The indiscriminatory use of this practice and hiding of the real situation has already been marginalized; however, what makes it even worse is the fact that this is a rate which is fixed among banks. This points to a more widespread fraud that was taking place between banks and there is more than one culprit. Names of Citigroup, HSBC, UBS and RBS have already been suggested and are being investigated accordingly.
This is another black eye for the financial system which has already suffered enough after the crisis of 2008 and the recent JP Morgan infamous $2 billion trading loss. The same incentive was used in the crisis as well where profit maximization was seen as a rationale for misrepresenting the actual situation and to gain an unfair competitive edge over its competitors. At this point of time, Barclays has been fined $450 million for this practice, however, it is only the tip of the iceberg as the investigation has been initiated which will uncover more names. Mervyn King, Governor of Bank of England, has asked the current system of LIBOR calculation to be scrapped and a new alternative to be decided which can increase investor’s bruised confidence in the financial markets.
The investigation will start off with hearing planned in the British Parliament from the head of investment banking, Bob Diamond under whose regime the rigging of the rate took place. This mirrors the hearing carried out by US Congress with Goldman Sachs officials and JP Morgan CEO, Jamie Dimon, in recent years. The outrage that is seen right now is justified as it is due to lack of checks and balances that these acts have been carried out over and over again and strict and stern laws and punishments have to be implemented in order to deter and curb these practices in the future. As the investigations find out more and more of this malpractice, only then will the extent of the fraud will be realized. Every day a new name would be brought to the foray and would be stricken down as it is supposed to. One thing that is more important at this point of time is to look into rules and regulations that regulate the investment banking industry and to have stricter controls put into place. The punishments will provide some relief to the anger that is felt but still a long term solution is required to marginalize this kind of behavior. A rap of the hand will just serve as a weak warning again and the traders will try not to get caught rather than stop these actions altogether. Now it is the responsibility of the respective authorities by using this case as a cautionary tale rather than an anecdote of the past. More to come as the days go on.
Zain Naeem is the head of equity research at Maan Securities (Pvt) Ltd. He is a Lahore-based commentator with more than 3 years of experience in trading and research at the Karachi Stock Exchange and Lahore Stock Exchange. He enjoys writing and commenting on the finance front and presenting it to various audiences in different forums. Zain is deeply interested in politics, business and finance and is fascinated at how the three intermingle with each other.