Libor: Deep trouble for a benchmark rate
Regulators are considering a question that could affect the way interest rates are set on a number of consumer financial products, including mortgages, credit cards and home equity loans: What do we do about Libor?
Short for the London Interbank Offered Rate, Libor is used as a benchmark for setting interest rates on many consumer and commercial loans worldwide. It's based on a daily survey of major banks conducted by the British Bankers' Association, which asks bankers for the interest rates they're paying to borrow money for a variety of different currencies and maturities.
The only problem? Sometimes those bankers lie, says Frederick Cannon, CFA, director of research at New York investment bank Keefe, Bruyette & Woods. This and other problems with Libor were reviewed by the Financial Stability Oversight Council, which made suggestions to replace Libor this year in its annual report.
Indeed, some of the world's largest banks, including Barclays, UBS and the Royal Bank of Scotland, have admitted to participating in a scheme to manipulate Libor by giving intentionally misleading answers on the Libor survey.
"That's where Barclays and others got into deep trouble because they had all those transcripts where they said, 'Hey dude, you put in Libor down 10 basis points, and I'll buy you a case of wine' and that kind of stuff," Cannon says.
Big money in manipulation
But regardless of government investigations and the many lawsuits being filed over Libor manipulation, it's clear the incentives to manipulate are enormous. Many banks have trillions of dollars' worth of contracts in which they are either paying or being paid amounts based on the movements of Libor, says Marti Subrahmanyam, professor of economics and finance at New York University's Stern School of Business.
"If the bank has got many other positions that are linked to this rate -- for instance, swap positions and other positions -- they have an incentive to manipulate the rate," Subrahmanyam says.
Moving Libor even a single basis point, or one-hundredth of 1 percentage point, in the right direction could be worth hundreds of millions of dollars to a bank, Subrahmanyam says.
When it comes to consumers, Libor manipulation probably didn't cost homeowners and other borrowers who pay interest based on the benchmark too much individually, but taken together, the cost of that malfeasance was likely quite high, Subrahmanyam says.
"If some thief could have gotten into your account and stolen a couple of pennies from every transaction you made, you wouldn't even notice it. And if he did this to thousands of people at a bank, he's going to make a ton of money," Subrahmanyam says.
Cannon says banks also may quote misleading interest rates to shape perceptions of their own financial health, as they did during the financial crisis. Just as with consumers, the interest rate a bank is able to borrow at is a reflection of the risk that it won't pay its debts. By quoting artificially low rates, some banks attempted to fool the market into thinking they were less affected by the stress of the financial crisis than they actually were, Cannon says.