Fin 5408 - Barclays and the Libor Scandal

Han Yufei

Fin 5408

Barclays and the LIBOR Scandal

1. What is the significance of LIBOR?

LIBOR is an incredibly important reference rate. Many contracts all over the world rely on LIBOR. It is a benchmark reference rate that was fundamental the operation of international financial markets and was basis for trillions of dollars of financial transactions. LIBOR was intended to represent the cost of unsecured funding in the open market for the largest financial firms. Whereas central banks would periodically fix official lending (or base) rates, LIBOR was designed to reflect the rates at which large banks borrowed money from one another each day; these rates were the foundation for what they would then charge their customers. Mortgages, credit cards, student loans, and other consumer and commercial lending products often used LIBOR as a reference rate. In addition, vast numbers of derivative instruments that traded in the over-the-counter market and on exchanges worldwide were settled based on LIBOR.

1. What problems does the manipulation of LIBOR create in the market?

Firstly, for one side of these transactions where the payer would benefit from a LIBOR that was set lower than otherwise because of manipulation, there was the other side that lost money it was legitimately owed. Besides, if the manipulated rate caused 1/8 remaining rates to be one bp different from the correct rate, the effect would be an actual LIBOR rate that was different by 1/8 of one bp. What’s more, the LIBOR which was changed and manipulated can’t reflect the real market situation. So people can’t accurately analysis the market on the basis of LIBOR.

1. What did Barclays do wrong?

First, the violations centered on submitted rates that were known not to be the best estimates of bank’s true borrowing cost, as influenced by the derivative traders and to avoid market scrutiny. The bank acknowledged that it had done two things wrong. First, rate Manipulation—between 2005 and 2009 it had submitted incorrect LIBOR rates to generate profits or reduce losses for its derivative trading desk, and for the benefit of traders at other banks. Second, lowballing LIBOR—between 2007 and 2009 it had submitted LIBOR rates that were lower than they should have been to try to avoid the perception that the bank was financially weaker than its competitors and dampen market speculation and negative media comments about the firm’s viability during the financial crisis.

Moreover, Barclays failed to have adequate risk management and control systems in place to prevent the fraudulent submissions. Finally, the firm failed to adhere to the Principles by not conducting its business with due care and diligence.

1. Why was the LIBOR process so easily manipulated?

We can easily get the answer form the setting process. Firstly, the U.S. dollar LIBOR is determined by only 16 banks, which is too few, and then Thomson gather the rates and using trimmed mean structure to create LIBOR. Secondly, panel banks quoted the rate at which they “could borrow funds” (rather than rates actually incurred), the process could lead to some deliberate misreporting. Furthermore, panel banks were asked to provide quotes that were subject to ambiguity along two dimensions—transaction size, which was not clearly specified, and maturities in which there was little or no interbank term activity.