What Is Libor and How Is It Calculated? How Has Libor Been Used Historically?
Essay by Vera Setiawan • May 11, 2016 • Essay • 2,592 Words (11 Pages) • 1,010 Views
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1. What is LIBOR and how is it calculated? How has LIBOR been used historically?
LIBOR is short for the London Interbank Offered Rate. It is the average interest rate at which major banks around the world borrow from each other. It is based on daily submissions to the British Bankers’ Association (BBA) from banks, which report their estimated costs of borrowing from one another. It serves as a benchmark for hundreds of trillions of dollars of loans and derivatives, including the cost of many mortgages in the U.S.
Each day the BBA asks major banks around the world how much they would charge other depository institutions for a short-term loan. The group takes out the highest and the lowest number and calculates the average from the remaining figures. The rate is published daily by the BBA at about 11:45 a.m. GMT. LIBOR is set by 16 international member banks. LIBOR has been the basis for consumer loans in many countries around the world. The interest on credit cards, car loans, and adjustable rate mortgages will move up or down with changes to the interbank rate. Its movement is crucial in determining the ease of borrowing amongst banks, companies, and consumers. While lower borrowing cost may sound attractive, not everyone benefits from LIBOR taking a dip. Some mutual funds and other securities are tied to LIBOR, meaning lower yields for certain investors.
2. What problems with LIBOR have been identified?
In article 1, some concern that (a) banks might report inaccurate rate quotes. Some banks do not want to report high rates they are paying for short-term loans because they do not want to tip off the market that they are desperate for cash. The (b) LIBOR system depends on banks to tell the truth about their borrowing rates. This could mean that millions of borrowers around the world are paying artificially low rates on their loans. That’s good for borrowers, but could be very bad for the banks and other financial institutions that lend to them.
Both these issues indicate that LIBOR is very subjective rather than objective. It is subject to manipulation and various parties’ interests.
3. Which institutions are involved? How have they been prosecuted? Why is there not a standard fine amount?
Many, if not all the 16 banks which set the LIBOR rate were involved, including Barclays, a major bank which admitted that it had lowballed its LIBOR rate so as not to appear financially weak in the eye of the public. Barclays argued that they did not benefits from under-reporting their LIBOR rate and had done so because it did not want to appear as an outlier (suggesting that other banks had actually been doing this under-reporting as well). Other banks include Citigroup Inc., WestLB, HBOS PLC, J.P. Morgan Chase & Co., and UBS AG.
There were no clear words on how the other banks were prosecuted, although Barclays had to pay $453 million settlement to US and UK officials for its wrongdoing and UBS $1.5 billion to UK and Swiss regulators[1].
A standard fine amount is almost impossible to be set due to the uncertain nature of the crime, the variable amounts of losses incurred, and the different parties which might have been involved in and hurt. This is something that has to be assessed on a case-by-case basis.
4. What are the root-causes of the problem? What incentives contributed to the problem?
Some of the root-causes which led to some banks under-reporting their borrowing rates are, first, (a) since financial crisis, banks have stopped lending to each other for periods of 3 months or more, so their estimate of how much it would cost to borrow involve a lot of guesswork. Second, (b) some U.S. banks such as J.P. Morgans and Citigroup have ample customer deposits and access to loans from the Federal Reserve, meaning they might not need to borrow at higher rates from other banks. Also, (c) there is fear of being seen as an outlier i.e. Any bank submits a much higher rate than its peers, it risks looking like it’s in financial trouble. Banks have an incentive to play it safe by reporting something similar -- which would cause the reported rates to cluster together.
Barclays, and similarly, many other banks, manipulated rates for at least two reasons: Routinely, from at least as early as 2005, traders sought particular rate submissions (a) to benefit their financial positions. Later, during the 2007–2012 global financial crisis, they (b) artificially lowered rate submissions to make their bank seem healthy.
5. What’s been the role of regulators (both U.S. and England) in the investigation and resolution?
Regulators play a very important role, especially in the midst of complex issues that implicate not only a small scale, but furthermore, the global economy along with numerous transactions involved. In the LIBOR case, the UK and US regulators were supposed to oversee data that were used for setting LIBOR, to ensure the accuracy of those data, and to enforce stringent rules and consequences to banks which seemed to try to manipulate the data.
However, although this is the desired and ideal case, the massive LIBOR issue unveiled indicates that regulators have not been doing a good job in this area. LIBOR had been long manipulated before and played around by many banks before the problems were eventually uncovered.
The Fed, as the US regulator, alleged that the UK regulators did little to implement the recommendation made by the US Central Bank in 2008. Top Bank of England officials defended themselves, saying that they were unaware that bankers were trying to manipulate the rate and that LIBOR is a private sector arrangement and was not subject to financial regulation. Some email exchanges also revealed that the central bank (Bank of England) was advocating a less stringent approach to governance of LIBOR instead. Although the Fed first recognized this problem in 2007 and notified UK regulators about this, there were no follow-up actions by the Fed’s own bank supervisors. The Fed instead gave excuses such as what was mentioned by Bernanke, that the Fed had no ability to change the way LIBOR is set. The Fed was also questioned why the issue of LIBOR had never been brought to the public’s attention right away.
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