The Sixth Estate

There’s been a great deal of nonsense in the press about the ongoing price-fixing scandal in the banking sector — in which, in case you haven’t heard yet, there is mounting evidence that for the past several years somewhere between 2 and 20 of the world’s largest banks colluded to manipulate a key interest rate index called the London Inter-Bank Offered Rate (LIBOR). And it seems everyone has an opinion on what to do about it. But National Post columnist Terence Corcoran takes the cake: Corcoran says that to prevent future manipulation, we need a genuine “market-driven alternative” in place of the LIBOR, which is too closely connected to “the tacit approval of central bankers and regulators.”

There’s really only one problem with this idea: the LIBOR is already set and administered privately. In his last column on the subject, Corcoran proposed “fixing” the LIBOR problem by passing new laws making it illegal to discuss LIBOR without paying a licensing fee to whatever new private bodies will be trusted with coming up with LIBOR’s key rate, or rather with LIBOR’s new “private” successor. The mind boggles. Corcoran should have stuck with one key comment in his piece, which I think speaks volumes: “I don’t pretend to understand the game, but here’s the explanation.” Yes, indeed. Maybe you shouldn’t write about it then? No?

Anyhow, let’s review the problem.

Right now there are essentially two key figures used to gauge the free flow of money in the banking sector. The first is the headline interest rate set by the central bank of a country (or of Europe, in the case of the EU). The central bank does deliberately move this rate up and down, theoretically in an attempt to control inflation and/or to lubricate a stalling economy. The central bank’s rate is the rate at which it loans money to private banks. The assumption is that when the Bank of Canada, for instance, lowers its key interest rate with the banks, the banks will have more money available to play with and will therefore lower the rates at which they lend money on to their own customers: other businesses and private citizens.

The second set of figures are inter-bank rates: the rates at which banks lend money to each other. And the leading measure of the inter-bank rates are the LIBOR rates. There is a LIBOR for each currency, and for each length of time a bank borrows money (for instance, there’s a three-month U.S. dollar LIBOR). The LIBOR may be used for anything from quickly gauging the health of the financial industry (a very high LIBOR would be an indication that banks are in financial trouble and unwilling or unable to lend to each other), all the way to setting an interest rate for a financial product, whether it’s a mortgage or a gamble on the derivatives market.

The LIBOR is calculated daily by a committee of leading banks, one for each specific LIBOR number, usually numbering around 16-20 banks in total. Every day, each bank on the committee submits its guess of the interest rate at which it could borrow money from other banks to the British Bankers’ Association, a private organization set up by the British financial sector. The BBA lops off the highest and lowest four numbers submitted, and publishes the average of the middle ones as that day’s LIBOR. This basic security step is taken to prevent one bank from skewing the numbers too much by submitting, either deliberately or accidentally, some wonky estimates on the day.

That’s how it’s supposed to work, anyways. During the credit crisis, it has emerged that a significant number of banks colluded to submit bogus numbers to the BBA, resulting in what was essentially a fake LIBOR. This went on for years; it’s hard to know, in fact, whether it ever stopped. Although now that the whole thing has come out in public, it probably has stopped. Barclays Bank has already paid a $450 million fine in exchange for its role in the scheme, and that’s just for a series of incidents which Barclays management contends were internal to its own bank and done without the knowledge of the higher-ups. Deutsche Bank, HSBC, Credit Suisse, UBS, Bank of America, JP Morgan, Citigroup, Royal Bank of Scotland, Societe Generale, and several others have all been said to be under investigation, although so far most of them have not yet been clearly implicated in any evidence made available to the public.

Exactly how large the conspiracy was, it’s hard to know, but logically, it would have to include at least a half-dozen banks. Submitting any false number to the BBA would game the system a little bit, but because the highest and lowest groups of submissions get tossed out every day, in order to really have an effect on the overall rates, you’d have to have enough banks involved to fill up the outlier groups and then some.

And as I say, I don’t know how far it went either. Curiously, Corcoran starts out by claiming that there’s “not a shred of evidence” that there was any attempt to manipulate LIBOR, “consciously or not,” by any bank whatsoever. But then, by the end of the article, he’s convinced himself not only that there is evidence (which to be clear there is, as any Google search can show you), but that the evidence implies that the main role in the price-fixing was probably played by central bankers and regulators, especially at the Bank of England, who leaned on the banks to submit bogus rates. Yes, indeed. I’m sure that’s exactly what happened.

And of course, that’s what leads Corcoran to call for the creation of a private “market-driven” index in place of the LIBOR, even though the LIBOR is already a private rather than government product, and even though it’s unclear why the banks wouldn’t lie to any “market-driven” service in exactly the same way they lied to the BBA. This would seem to be an unusually obvious case of the need for a publicly regulated system to ensure honesty in the markets. Not so, says Corcoran.

By way of closing, it’s worth noting that we don’t yet know how much people actually lost as a result of the banks’ collusion. The banks didn’t necessarily do this to rip off their customers. In fact, it seems that their first motivation during the crisis was to make interest rates appear artificially low. In 2008, many banks grew paranoid about their neighbours, unsure which bank was about to become the next Lehman Brothers or Bear Stearns, and so inter-bank lending slowed and rates shot upwards. That was when the banks are alleged to have begun sending in false LIBOR numbers, and they were sending in falsely low numbers in order to imply that, quite to the contrary of what was really going on, everything was fine and dandy and the banks were still willing to lend to each other at normal rates, even when actually they weren’t.

Moving on from there, it seems that the second motivation was collusion between the banks’ rate-submitting offices and their trading divisions, who were trying to manipulate the LIBOR in order to shore up and exploit their positions in the multi-trillion-dollar global derivatives market. In short, some banks were gambling heavily on certain positions in the derivatives market, and their profits on those positions went up when they were able to artificially push the LIBOR in particular directions.

So, on the whole, it’s going to be difficult to disentangle who actually got hurt by LIBOR, and if so, by how much. But it’s certainly increasingly clear that for a period of several years, several of the world’s leading banks deliberately contributed to a false picture of the health of the banking industry, for their own benefit. That’s what the LIBOR scandal is all about, and as long as we trust the banks to tell us what rates they’re borrowing money at, that’s the sort of manipulation we will remain vulnerable to.