Interest Rules- Another Chapter In The Libor Scandal
Regulators in the US, UK and Switzerland are poised to hit banking giant UBS with a whopping $1.5 billion fine The latest episode in the Libor rate rigging scandal involves over 30 employees, and several traders have already been arrested (The Telegraph).
Libor is the benchmark reference rate used to calculate interest on trillions of dollars of loans and derivatives. It has been controlled by the British Bankers Association (BBA), and stands for London Interbank Borrowing Rate, the rate banks charge each other. Major London banks submit rate quotes for loans in various currencies and of various maturities; the BBA averages them and quotes the official Libor rate for that data pair. The latest scandal involves the yen-pound sterling rate. Users of Libor rates generally take a given Libor rate and add a credit spread to it to determine the all-in rate they charge a customer.
Why does this matter in an environment of record low interest rates? First, the gaming started when rates were considerably higher. Traders would fudge a rate to avoid damaging a trading position they owned. At other times, they would understate a quoted rate to mask credit problems at their bank and its actual costs of funding. Even in a low rate environment, the cumulative costs can be staggering. For example, if a bank fudged a Libor-USD rate and bumped the average from .50% to .55%, that would add five thousand dollars of interest annually to a ten million dollar loan. If it did the reverse, it would be victimizing its depositors and shareholders by a like amount. When one plays these calculation games with trillions of dollars of financial instruments, staggering distortions in the credit markets occur.
The financial markets do not need another scandal right now. They are already shaken by the real estate bubble of the last decade, the inventory of hugely troubled assets, insider trading scandals and now this. Financial markets require a baseline of trust and transparency to operate properly. The government cannot regulate everything, and its own credibility has been badly damaged by defacto imposition of price controls via extremely aggressive quantitative easing programs designed to artificially lower rates.
The whole mess reminds me of one of my favorite English sayings: “Too clever by half”. Indeed.
Graphic courtesy of moneysigns.net