Labouring over Libor

Written by Saikat Neogi | Updated: Jul 19 2012, 08:27am hrs
What is Libor

The London Inter-bank Offered Rate (Libor) is an interest rate at which banks can borrow funds from other banks in the London money market. The rate is fixed on a daily basis by the British Bankers Association. Countries that rely on the Libor for a reference rate include the US, Canada, Switzerland and the UK, and the interest rate benchmark is used for financial products ranging from loans to derivative contracts globally valued at $360 trillion or about $50,000 per human being. Some 16 of the worlds biggest banks are polled daily on the rate they would charge to borrow over a variety of short-term maturities15 different maturities ranging from overnight to one yearin 10 different currencies including dollars, euros and yen.

How did banks rig the rates

Authorities in Europe, Japan and the US are investigating suspected rigging of Libor. So far, the second biggest bank in the UK, Barclays, is the only bank to admit that it influenced the rate by not giving an honest quote, intended to benefit its own trading positions. It was actually low-balling submission of rates for the benchmark after the the global financial crisis. Various reports suggest that the manipulation started way back in 2005 and continued till 2009. The Financial Services Authority (FSA) of the UK has fined Barclays a record 290 million pounds ($450 million) for submitting false rates for Libor. The fraud also cost Robert Diamond, the banks chief executive officer, Marcus Agius, the chairman, and Jerry Del Missier, the chief operating officer, their jobs. Deutsche Bank, Royal Bank of Scotland, UBS and Lloyds are among the lenders regulators in Europe, Asia and the US are investigating.

Did anyone get an inkling that manipulation was going on

In June 2008, Timothy F Geithner, the US secretary of the treasury, who was then president of the Federal Reserve Bank of New York, had sent Bank of England governor Mervyn King recommendations to revamp the Libor and wanted procedures to prevent misreporting. The recommendations included one to establish and publish best practices for calculating and reporting rates, including procedures designed to prevent accidental or deliberate misreporting. He also suggested adding a second USD Libor fixing for the US market.

How will this affect borrowers

News reports suggest that some long-term investors like pension funds have started evaluating the damage. The California Public Employees Retirement System, the largest US public pension fund holding over $200 billion of assets, is examining the impact of the Libor fixing on its portfolio. In the US, the Office of the Comptroller of Currency estimates that 9 lakh outstanding home loans, which carry an unpaid principal balance of $275 billion, are indexed to Libor that originated from 2005 to 2009the period the benchmark was rigged. During that period, the banks were allegedly pushing up the rates, which means households were paying higher rates. Gabriel V Rauterberg and Andrew Verstein of Yale Law School estimate that a modest manipulation upward in Libor could easily extract $1,000-2,000 per year from a typical sub-prime borrower. They also note that a lower Libor induces a lower mortgage rate, makes it easier to buy homes and substitute homes away for other goods. This artificially inflates the prices of homes having the potential to lead to bubbles and meltdowns of the type we are currently experiencing, the authors says in the research paper Index Theory: The Law, Promise and Failure of Financial Indices. So, while investors in the US and the UK have started filing lawsuits against banks for the alleged manipulation, households could be next to file class-action suits.

How will this impact Indian borrowers

The ripples of the manipulation will be felt in India too as most foreign borrowings by corporate India are linked to Libor. For their domestic expansion, overseas acquisitions and even for working capital needs, External Commercial Borrowing has been a major source of finance for companies. From 2006-07 to 2010-11, total ECB inflow was around $120 billion and the spreads paid out by Indian entities during the period have ranged between 300 and 500 basis points over Libor. So, a higher manipulated Libor rate means higher borrowing cost for Indian companies.

What is the Indian version of Libor

The finance ministry has asked the Reserve Bank of India to look into the implication of Libor manipulation on Indian banks and corporates who have borrowed money from abroad. The Mumbai Inter-bank Offer Rate (Mibor), jointly polled by NSE and Reuters, poses no threat of a scam as it is much more transparent, according to a finance ministry official. There is little chance of Mibor getting manipulated as volumes transacted are not large and polled institutions are dominated by public sector banks.