You may not be interested in the Libor—the London Interbank Offered Rate—but the Libor is interested in you. Even though the typical American is never going to seek an interbank loan in London, the number is used as a benchmark for a wide range of other financial instruments. Credit instruments with variable interest rates—private student loans, auto loans, adjustable-rate mortgages, credit cards, etc.—need to be indexed to some underlying marker of the overall cost of funds within the financial system. Often that’s something called the “prime rate” set here in the United States, but it’s also frequently the Libor. So growing evidence that Libor numbers have been deliberately manipulated by banks for years means that millions of people have been paying the wrong interest rate on all manner of financial products. Vast sums of money have been wrongly snatched from innocent people and created equally vast undeserved windfalls for others. The basic structure of the world’s financial system has once again been exposed as fundamentally broken.
Libor is calculated by the financial information and news company Thomson Reuters for the British Bankers’ Association, based on daily submissions from BBA member banks. The submissions are not based on an actual market rate of interest for interbank loans. Rather, submitters estimate what they think they would have to pay. High and low submissions are thrown out, the remainders are averaged, and voilà: the Libor.
If this sounds like a remarkably flimsy form of economic data, it is. It’s just a guess, not a real measurement of anything. And it’s generated by a trade group, not a regulatory agency. And it’s self-reported, not based on any public data. But over the decades Libor came to take on a foundational role in prosaic economic transactions. In a world of large multifaceted financial-services firms, the quirks of the Libor process were a conflict-of-interest disaster waiting to happen. One unit of a BBA member bank could be cruising along, minding its own business, doing its morning Libor submissions, while another arm of the bank was trading interest rate swaps, currency futures, or other derivatives. Some of those trades’ successes or failures could come to hinge on whether the Libor went up or down. But the Libor’s not external to the banks’ activities, and it’s not an objective measurement of anything. A bank could try to tailor its Libor submissions to meet the needs of its trading desk rather than offering good-faith estimates.
And according to ongoing investigations in the United States and the United Kingdom, that’s exactly what happened. The dirt we know right now comes overwhelmingly from one bank, Barclays. But that’s because Barclays chose to turn rat and cooperate with the investigation, not because they were the only ones messing around. For now, though, the best documentation of the scandal is a series of hilarious emails between the bank’s traders and the bank’s Libor submitters, with traders expressing gratitude for fudged numbers in terms like, “Dude. I owe you big time! Come over one day after work and I’m opening a bottle of Bollinger.”
As the global economy went into crisis, the Libor-fixing turned more alarming. In principle, prevailing interbank lending rates are an excellent measurement of the overall health of the banking system. Low rates indicate that bankers have a high degree of confidence in the other banks, so the published lending rates turn insider gossip into public information. But during the crisis, British regulators seem to have encouraged BBA members to collectively lowball their bids in order to project an appearance of health.
The collective lowballing is perhaps defensible as the financial regulatory equivalent of ordering the code red. A few bent rules here or there are a small thing compared to the disastrous fallout of a systematic banking crisis.
Rigging the Libor submissions for the sake of trading profits, by contrast, is emblematic of exactly the sort of situation that puts us at risk of such crises. The problem here isn’t really that some people ended up losing money because interest rates were rigged to be higher than they should have been. People did lose money in this way, and it looks like the losses should lead to ample litigation.
The real issue is just that international finance has become a ruthlessly competitive game in which firms relentlessly seek newer and bigger profit opportunities. At the same time, important swathes of the system are stuck in the days of the old boys’ club where important measures were handled essentially as gentlemen’s agreements. Setting the Libor through a fairly informal submission system and then using it as the basis for global interest payments created a massive arbitrage opportunity: Anyone who was willing to game the gentlemen’s agreement could arrange vast, riskless profits. And today’s cutthroat finance is nothing if not brilliant at arbitrage. In particular, it’s gotten frighteningly good at arbitraging away effective regulatory oversight. Time and again problems have arisen when clever bankers have found clever ways of undermining the intention of regulatory systems. The Libor malfeasance lays bare in an unusually clear way the basic fact that a modern bank is perfectly happy to lie when there’s money to be made. This has scandalized elements of the business establishment, especially in Britain, leading to a striking Economist cover image labeling the perpetrators “Banksters.”
So far the shock waves haven’t really hit on this side of the Atlantic, but one can only hope they will. The United States enacted a major change in its financial regulatory system in 2010, but it’s not clear that we’ve yet had an adequate change in regulatory attitude. The lesson of Libor is that regulators need to recognize that bankers have cast aside the clubby values of yore, and they need to respond in kind. Banks will try to abide by the letter of the law, but where loopholes exist, they’ll be ruthlessly exploited—through dishonest means if necessary—and the financial cops need to have a fundamentally suspicious attitude toward the regulated entities. Time and again, when tighter regulation of trading is proposed, the concern is raised that stringency will push activity to foreign centers. In the short run, that’s almost certainly true. Banks will want to move to wherever they’re most likely to be able to get away with more shady dealings. But an economic development strategy based on turning your country into an appealing location for dishonest banking is just going to get you a financial system that’s rotten with dishonesty. It’s time to stop being surprised and start realizing that these are the inevitable fruits of a regulatory system that’s weak by design.