Summer in the City or the lingering LIBOR hangover

What exactly is LIBOR?

LIBOR is an average interest rate calculated through submissions of interest rates by major banks in London, it represents the prices banks pay to borrow from each other. It is no exaggeration to say it provides the underpinnings of the financial industry, as the LIBOR rate affects $300 trillion of financial products all around the world. Financial products affected by LIBOR rates include mortgages, personal loans, financial derivatives, thus any manipulation of LIBOR rates ultimately may have significant negative effects not just on financial institutions but indirectly on consumers.
LIBOR (the London Interbank Offered Rate) is calculated by Thomson Reuters on behalf of the British Banking Authority (“BBA”). Contributing banks submit a response to the following question for each currency: “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?”
The highest and lowest submissions are discarded, with the remaining submissions averaged to create LIBOR for the given day.

Is the traditional mechanism a relic of the past?

How could these scandals have occurred? Maybe because there is no explicit regulation of the LIBOR process. LIBOR setting has worked for 25 years essentially on a trust and honour system.
But the scandals this summer, with Barclays Bank receiving a record GBP 290 million fine for rigging the rate in its daily submissions to the BBA and around a dozen other Libor-submitting banks still under investigation, including HSBC, Deutsche Bank, UBS, Royal Bank of Scotland and JP Morgan Chase, have created a massive credibility crisis in the underpinnings of the financial system. This summer’s LIBOR scandal helps supporters of self-regulation load their guns and will no doubt lead to a more regulated and supervised financial industry. The European Commission has announced plans to make the manipulation of benchmark interest rates like LIBOR a crime and has also criticized the U.K. regulators as being too lax.

What happens next?

In the aftermath of the Barclays fine, the UK Treasury commissioned a report to provide recommendations for the reform of the Libor mechanism. The report, known as the Wheatley Report, overseen by Martin Wheatley, the managing director of the FSA (Financial Services Authority) was released at the end of last month. Wheatley stated “The system had in-built conflicts of interest from the start – banks could submit what they wanted - and with traders’ bonuses dependent on the LIBOR rate, and no bank wanting to be seen as vulnerable in such a transparent system, too many people had a vested interest in gaming the system … the BBA acts as the lobby organization for the same submitting banks they nominally oversee, creating a conflict of interest that precludes strong and credible governance.”

Meanwhile the Financial Times reported this week that a series of class actions have been filed in New York concerning individuals claiming damages over inflated mortgage payments due to the alleged LIBOR manipulation. The action is being led by a pensioner whose home was repossesed after her LIBOR based mortgage led to unaffordable payments. Her attorney claims there may be as many as one hundred thousand plaintiffs.

Part II of this article will examine the specific recommendations of the Wheatley Report on LIBOR.