What is "Libor"?
“Libor” is an acronym that stands for “London Interbank Offered Rate,” which is a benchmark interest rate that is derived from the rates that major banks charge each other for loans in the London interbank market. Each day at 11:30 am London time, banks report their estimated borrowing costs to Thomson Reuters, which publishes the average of these estimates in the form of the Libor benchmark interest rate. The Libor is calculated for five different currencies and seven different maturities up to one year.
As the world’s most important benchmark interest rate, the Libor is used as a reference rate for hundreds of trillion dollars worth of commercial and consumer loans, derivatives, and other financial products across the globe. Libor-based loans are quoted using the Libor rate plus a certain number of basis points, which depends primarily on the particular lending institution, the type of loan, and the borrower’s creditworthiness. For example, a loan’s interest rate may be quoted at “157 basis points over 1-year Libor”, which equates to 1.57 percent plus the current 1-year Libor rate. The 1-year U.S. dollar Libor rate is currently 0.535 percent, so the loan in this example would have an interest rate of 2.105 percent.
The Libor Rate-Fixing Scandal Explained
In June 2012, a scandal ensued after it was revealed that major banks – particularly Barclays, UBS, Rabobank, and the Royal Bank of Scotland – had been manipulating the Libor for their own benefit since at least 1991. As mentioned earlier, the Libor is used as a reference rate for hundreds of trillions of dollars worth of derivatives – a market that is dominated by big banks. Traders at numerous banks had colluded with each other to submit fraudulent daily Libor rate submissions so that they could boost the profits on their derivatives positions as well as create the illusion that the banks were in a healthier financial condition than they actually were during the Global Financial Crisis.
Because of the large notional amount of derivatives and loans that banks hold, even minuscule changes in the Libor rate can equate to millions of dollars worth of profits or losses. For example, Citigroup stated that it would have generated $936 million in net interest revenue in the first quarter of 2009 if interest rates fell by 25 basis points or .25 percentage points, and $1.935 billion if rates fell by 1 percent. A Barclays trader’s instant messages that surfaced during the Libor scandal investigations showed that traders could earn ”about a couple of million dollars” for every .01 percent that Libor was manipulated in their favor.
The derivatives market is a zero-sum game in which there is a loser for every winner, so all of the fraudulent profits that banks and traders earned from manipulating the Libor came at the expense of other unwitting parties that were on the other side of their trades. Many of these losing counterparties were not savvy speculators or banks, but parties such as U.S. municipal governments that lost approximately $10 billion on their derivative hedges and U.S. homeowners who paid higher mortgage rates as a result of the manipulations. In addition to the realized financial losses, Libor manipulation harmed the integrity of the global financial system and served as another confidence blow at a critical time during the financial crisis.
After a lengthy and ongoing investigation into the Libor scandal, U.S. and European authorities have fined the institutions that were involved with the manipulation a total of $6 billion and pressed criminal charges on twelve people so far. According to an estimate by securities broker and investment bank Keefe, Bruyette & Woods, the guilty institutions may eventually pay approximately $35 billion in legal settlements in addition to regulatory fines.
