LIBOR: Fiddling in the Banking Vatican

Collusion.

It's a dirty word that makes a lot of money until someone proves it. Then it costs a lot of money.

And recently, Bloomberg has been abuzz with the LIBOR-fixing collusion scandal. The banks have been scurrying around not commenting and/or selling other banks down the river. The river Thames, presumably. With the pollution and the pikeys, and a cruise that ends at the Tower of London where lots of famous people have rather famously lost their heads.

But before we get to the head-rolling, some background information. I'd like to start with: what is LIBOR, and why is it important? 

What LIBOR Is

LIBOR is an acronym for the "London Interbank Offered Rate": which translates to "the rate that Bank A would charge Bank B if Bank B wanted to borrow money from Bank A". LIBOR is set every day, in 10 different currencies and for 15 different maturities. So by "LIBOR" what we actually mean is the reference list of all 150 LIBORs. And why is LIBOR important? Well, there are two potential answers to this:

1. The first is that LIBOR is used as the benchmark rate by most of the finance world for almost any transaction. The list of affected instruments is long: standard loans, bond issues, swap agreements, mortgages, forwards, futures, variations of any of these, etc. Not all instruments need to be LIBOR-linked - but it is the general convention for a market worth around $350 trillion. The real question is why is LIBOR the convention? Which leads me to:
2. The City of London is the home of international finance; much more so than any other centre historically. It is also the heart of the most established and long-standing network of tax havens. And by "City of London", we are talking about the square mile stretch in the middle of Greater London: the part that is practically self-governing, where businesses are allowed to vote in elections with a vote-weight proportional to the number of people they employ, and the business vote far outweighs the residential one. It's the banking version of the Vatican. The tax authorities are the minions of Satan, the CEOs are the Cardinals, and the Banks are the monastic orders with their missionary outposts on small tropical islands where much of the real work is done. And Jim Rogers is the Pope with the strange clothing that they roll out on special occasions. And Warren Buffett is Richard Dawkins. And Mitt Romney is a still mormon. 

If anyone has ever wondered how it is that such a small country sets the benchmark interest rate for the world of finance (as compared to, say, New York), the answer is lying there in point 2 above. But that's a topic for another post. The point is that, for quite good reason, LIBOR has become the conventional benchmark rate for most international banking transactions. 

So immediately, it becomes obvious that if there were a small opportunity to influence that rate, one would probably try exercise it (exorcise it?). Particularly if you're a bank. Tiny differences in the rate of interest have dramatic impact when you look at the volume of financing that operates off the LIBOR. To say nothing of how useful it would be to know what direction LIBOR will be taking before it's officially announced each day.

The LIBOR Determination Process

And how do we get LIBOR? The LIBOR list is published daily by the British Bankers' Association (BBA) - or, to continue the fun metaphor, the College of Cardinals: who conduct a Mass survey every morning, and distribute the sacrament to the laity just before noon. The actual ritual is as follows:

1. Every year, the BBA selects between 8 and 16 banks to sit on a panel (one for each type of currency).
2. At around 11am, BBA calls around and asks each banking panel member what they would expect to pay to borrow substantial amounts of money at the range of different maturities.
3. The BBA then collates the data, and eliminates the top 25% and the bottom 25% of the results.
4. The middle 50% is then averaged to give the official BBALIBOR rate.
5. Thomson Reuters publishes LIBOR on the BBA's behalf at about 11:45 am.

One small point (easily ignored): the panel banks aren't meant to speak to each other about their rate suggestions before the BBA calls them each morning.

Hmmm.

A vow of silence before lunchtime?

But cardinals are such chatty creatures!

And as the world is freshly discovering (cue: the resignation saga of Goldman S), gone is the old school British system of stiff upper lips and being invited round for tea with the BoE Governor when the chaps are concerned that you're having a bit of a lark and well, dash it all, but it seems to be affecting the stability of the pound a tad.

No. When the old school were lads, it was all about what one ought to do. Now it's all about what one can get away with - and clients be damned for fools if they fail to realise that what one can get away with is their money.

The Scandal Starts

So what exactly is the price-fixing scandal? Well - everyone is concerned with the period between 2006 through 2008. In 2008, the Wall Street Journal first started reporting rumours of potential price-fixing, and investigation was taken up by the US Department of Justice and the SEC (the Securities Exchange Commission - which the US regulator watch-dog, although the pooch is mostly blind and toothless).

The main reason for the rumour: one of the banks reported that it could borrow three-month LIBOR at 87 basis points less than the benchmark rate for credit default insurance bought on the bank's borrowings. What does this mean?

Well, let me start by saying that Credit-Default Swap spreads are seen as a measure of the risk of default. So if Bank A wanted to lend money to Bank B and cover itself for the risk of Bank B defaulting: Bank A would earn interest from Bank B, and buy protection from an insurer by paying an insurance premium (being the credit-default swap spread). In order for Bank A to make a profit, the interest rate would have to be higher than the credit-default swap spread. If the interest charged is lower, then Bank A is accepting that it makes a loss. As is illustrated below:

So when the bank in question tells the BBA that it expects to be able to borrow at a rate below its credit default spread, that means that it can approach a lender who will willingly take a loss. Likely? I think not. The article was published by the Wall Street Journal (Link: Study Casts Doubt on Key Rate).

Despite this, the Europeans and the IMF loudly declared that the allegations seemed baseless. Which must have been fairly expedient at the time - the world's financial markets were mid-reeling from the collapse of Lehman Brothers and such.

And in the turmoil that followed, it seemed that things were forgotten. At least, by the news reporters.

And Now

In the last few months, however, the Antitrust criminal investigation has gained greater steam. UBS has been granted conditional immunity by the US and the Swiss after agreeing to co-operate (this is the technical definition of "selling up the river"). And there are many lawsuits being lodged by angry investors (obviously), who are being denied access to documents until the Department of Justice wraps up its criminal investigation.

And thus, in the sacred halls of big banks, Antitrust is revealed to be Antichrist.

And if we extend the story any further, Antitrust will reign for a period of time, and then the Son of Goldman will ride in on his White(HouseLobbyist) Steed and establish His reign for 1000 years (because time is money, after all).

I'm calling it. The criminal probe will end in a civil lawsuit that the banks will settle and not have to admit to having done anything wrong.

And then the Chinese will take over, institute the Middle Kingdom of Heaven, and this will all be largely irrelevant.