Growing LIBOR Scandal Exposes Flaws
Professor Nejat Seyhun says bank manipulation of interest rate benchmark shows need for increased regulation, and says banks may be forced to pay princely sums to settle claims.
ANN ARBOR, Mich. — The more details are revealed about how banks allegedly manipulated the benchmark London Interbank Offered Rate (LIBOR) the worse it looks. LIBOR is used as a benchmark for setting interest rates on all kinds of loans around the world, from interbank lending, to corporate bonds, to home mortgages. The leadership of Barclays was sent packing over the scandal and the British bank paid $450 million in fines to U.S. and U.K. regulators. More recently, the New York attorney general subpoenaed JPMorganChase, Citigroup, UBS, and Barclays for information. Finance professor Nejat Seyhun said it appears several banks (if not all 16 British Bankers Association (BBA) panel banks) colluded to report false information to manipulate so they could make money on derivative trades. He says they also appeared to keep the rate artificially low before and during the 2008 financial crisis. Offending banks could be on the hook for millions, or more, in claims from counterparties who wound up on the wrong end of interest swaps and Eurodollar futures tied to LIBOR. For Seyhun, the Jerome B. & Eilene M. York Professor of Business Administration, that behavior is proof banks need more oversight. He also thinks we can find a different benchmark for interest rates. Seyhun's research has focused on the backdating of executive stock options, intra-day impact of insider trading, and the long-run performance of IPOs. His backdating research helped expose a widespread scandal.
To help us see how LIBOR was manipulated, how is it set?
Seyhun: The British Bankers Association (BBA) enlists Thomson Reuters to survey 16 banks to ask what interest rate they would expect to pay if they asked for and then took a dollar denominated loan from another bank. These submissions get processed by averaging the inter-quartile rate, after the highest four and lowest four numbers are thrown out. So with 16 banks and the eight outliers thrown out, regulators thought it was pretty tamper-proof. But they didn't figure on widespread collusion among the banks.
How was the system manipulated?
Seyhun: It was manipulated in multiple ways, going back to 2005. Eurodollar futures traders and Eurodollar derivatives traders at these banks started telling the people at their bank who submitted the rate to Thomson Reuters to change what they reported either above or below the true borrowing rate. Many times they did this right around the expiration of the futures contracts. That way, the traders knew what the change in LIBOR would be and they took large derivatives positions on trades based on that. Banks are borrowing and lending in the interbank market constantly, so the traders know minute-by-minute what the true rates are. But for that manipulation to work, there would have to be collusion, since the outliers are thrown out when BBA figures the average as LIBOR. According to the emails in the Barclays settlement with regulators, there was collusion with other banks' traders.
This has already cost both the chairman and the CEO of Barclays their jobs and the bank paid $450 million to U.S. and British regulatory agencies. Will more shoes drop?
Seyhun: Oh, yes. This was just one settlement with two regulators. There will be additional charges by the regulators. In addition, the private claims between institutions are going to be rather large. To give you an idea, the swap market based on LIBOR alone is about $500 trillion in notional principal. The Eurodollar futures market is similar in size. What banks pay in regulatory fines could be peanuts compared to what they might end up paying to settle private claims from counterparties in those trades.
If this started in 2005, why did it take so long to discover?
Seyhun: That's the big question, and I don't know exactly why. I think we will get more answers to this question over time. For one thing, there have been hints that central bankers in the U.K. and U.S. may have been aware of these manipulations very early on. However, the nature of the interbank market is private so we don't know the exact rates at which banks are borrowing and lending. We know what they are reporting for LIBOR, but we don't see the other side — the actual transaction rates. Even so, there were suspicions of manipulations going back to 2007, at least.
This collusion wasn't the only manipulation. Starting around late-2007, banks were worried about how risky they appeared both in absolute terms as well as relative to each other. To address this concern, banks began suppressing their LIBOR submissions. So, with orders coming from directly the CEO's office, it looks like Barclays did not want to be left as the odd man out, and that bank also began to suppress LIBOR to make it look like they were not the riskiest bank and they were paying less interest than they actually were. This made them appear to be less risky and more healthy than they actually were. This was in the run-up to the financial crisis of 2008. This suppression reached a maximum right after Lehman's failure on Sept. 15, 2008.
If you looked at the LIBOR submissions by the 16 banks, they were very highly correlated and highly suppressed at the very height of the financial crisis. The picture suggests there was collusion and coordinated suppression. The Federal Reserve measures interbank deposit rates, and there's a large divergence between what it measured and what the banks reported. In fact, many banks reported that they were paying more than 200-basis points less in the interbank market than what the Fed was measuring from its own survey. The Federal Reserve surveys other banks in addition to the banks contacted for LIBOR reporting, so it certainly knew there was a divergence between what it measured and what the banks reported. Fed Chairman Ben Bernanke hinted they knew about this, but then defended the Fed by saying that he thought everyone else knew about the manipulations as well.
Central bankers of the world are scheduled to meet in September and discuss LIBOR. Bernanke has called it structurally flawed. Might they scrap it in favor of something else? If so, what else could you tie interest rates to?
Seyhun: You could tie it to U.S. Treasury bills or notes. Rates for long-term loans could be priced off of 10-year T-Note rate and the short-term loans could be tied to one-year T-bills. We don't really need LIBOR.
Could this be the end of LIBOR as an important benchmark or could the system be reformed?
Seyhun: They could reform they system by asking the banks to report rates on a number of actual, recent transactions in the interbank market (along with the counterparty information). That way we would know what they're paying instead of relying on them to tell us what they're paying. They could still cheat, obviously, but now counterparties would know immediately that the banks are reporting false rates.
How bad is this scandal from a market credibility perspective?
Seyhun: This is pretty bad. This underlies the importance of why we need to regulate the banks. One of the cornerstones of the Dodd-Frank Act is increased transparency. This scandal highlights the importance of why the banks need to be more transparent. If they are not transparent, the banks are going to take advantage of their informational advantage and use it against counterparties if they think they will get away with it.
The outrage on this has seemed muted, at least in the U.S. A lot of firms who suspect they were on the bad end of some of these trades are seething, of course, but it hasn't really grabbed the public. Why not?
Seyhun: Partly it's because a U.K. bank, namely Barclays, basically settled, admitted guilt, and is cooperating with authorities. It's naming other banks. So far, none of the American banks have admitted their guilt. So the other shoe will drop here when the American banks are implicated and/or if they publicly admit their guilt and cooperate as well. Then I think we'll see more outrage in the U.S. The American banks are saying it's all on the other side of the ocean, and it doesn't reach into the CEO offices in the U.S. as it did in the U.K. We'll see.
— Terry Kosdrosky
For more information, contact:
Terry Kosdrosky, (734) 936-2502, firstname.lastname@example.org