[Economy] LIBOR Scam : Meaning, Reasons, Consequences, Timeline, explained

1. What is Libor?
2. Ya but why do banks lend each other?
3. How do banks borrow in London?
4. Who calculates LIBOR?
5. How does BBA calculate LIBOR?
6. Why does BBA calculate LIBOR?
7. What’re the Implications of LIBOR
8. Why LIBOR scam?
9. What is Barclays?
10. Wrong Data= Wrong Average
11. Timeline of Events

What is Libor?

• Suppose SBI and BoB (Bank of Baroda) are London based Banks.
• If Bank of Baroda borrows money from State Bank of India, say 1 crore pounds for 1 month @12% interest rate.
• Then 12% is the London Interbank Offered Rate (Libor).

In short, LIBOR= the interest rate at which banks borrow and lend from each other in London. (i.e. SBI is “lending” @12% and BoB is “borrowing” @12% interest rate, but either way the interest rate is 12%.)

But this is a technically not so correct definition. Because there ought to be more than two banks in whole London and all of them can’t be lending to each other at the same interest rate, right? We’ll come to that problem very soon but first of all.

Why the do banks lend each other?

• In every country, there is one RBI (Central  Bank) and there are some SBIs,BoBs etc. (Commercial banks). Usually, the SBIs take deposits from customers and some loans from RBI and lend this money as home/car/bike/business/personal loan to other customers. So why do these banks need to borrow from each other?
• Well, there are days when more customers have made withdrawals than deposits. (e.g. before Diwali / Christmas or IPL cricket betting) so a Bank has to borrow from its rival banks to cover the shortage of cash. It is not necessary that  a bank is running into losses and  hence borrowing from the other banks. Because a bank would have loaned the money to other customers for 5-10-20 years’ period so it can’t immediately recover all the cash in one day.
• On the other side, banks with a cash surplus can make extra profits by lending its cash to a rival bank.
• Thus, Banks lend to each other on a short-term basis to either to cover the shortage of cash or to make a profit.

How do banks borrow each other in London?

• When you want to take car- loan, you visit various bank branches, take their brochures, if you’re tech-savvy you might just visit the website of all famous banks and compare their interest rates, loan terms etc. So, there is total transparency about interest rates,
• But when one bank has to borrow from another bank, such transactions take place via phone-conversations between their executives, there is lot of give and take, bartering etc. for example-
  if your bank promises not to setup any ATM booths around Gujarat university for next five months and i’ll reduce the interest rate!
  another case
  I know your 20,000 crores rupees are stuck in the loan given to that Mallya. So you’re in no position to negotiate. Give me 18% interest else I won’t offer any loan.
• In short, there are many variables and behind the curtain deals.
  We can know the buying and selling price for shares of Infosys by glancing at the Nation Stock Exchange website/ screen/ CNBC or similar business news channels.
• However, there is no comparable screen where we can learn the LIBOR.
• For the last 26 years, the British Bankers’ Association (BBA) has computed Libor by asking dealers what they saw as prevailing market conditions, deleting the high and low values of the reports, and taking the average of rest data.

Who calculates LIBOR?

• It is calculated daily by British Bankers’ Association. (BBA)

How does BBA calculate LIBOR?

• Every day, 16 banks in London, will send SMS to the BBA Manager, giving the the interest rate that they are charged to borrow money.
• The BBA manager will delete the four highest rates and the four lowest rates.  And then he’ll take average [mean] of the remaining data.
• Thus, The average of the eight remaining rates = Libor rate.

Why does BBA calculate LIBOR?

• If a bank is weak and unlikely to repay money on time then the rival banks will demand higher interest rate while lending money to that weak bank.
• Means, A bank has to pay a higher interest rate to borrow funds if other lending banks have less confidence in it.
• So, The rate each bank has to pay is in part a reflection of their rivals’ perception of its financial strength, effectively how much it is trusted.
• This means that the Libor rate gives an indication of the health of the wider banking sector.
• Euribor=plays the same role for banks based in the eurozone.
• SIBOR =for Singapore
• HIBOR=for Hongkong

What’re the Implications of LIBOR

• In UK, the Banks charge interest rate on home loans according to LIBOR. If LIBOR increases then home loan interest rate also increases.
• Even in USA, majority of the home loans were linked to LIBOR rate (in 2008).
• Same case for business loans.
• Same case for students’ (education) loans.
• Many Futures and derivative contracts in forex, commodity and oil market are based on LIBOR rates.
• In short, The prices of trillions of dollars worth of financial transactions around the world are set according to Libor.
• Indirect implications are many (both positive and negative), for example, If a businessman in US or UK has to pay more interest rate for getting loans,

1. He may increase the price of his products.
2. he may reduce the number of employees or
3. he may be outsource the work to India and Philippines to reduce the operational costs.
4. he may scale down his operation, thus reducing the amount of raw material / input products imported from India. and so on…

Why LIBOR scam?

• Recall the earlier statement: “A bank has to pay a higher interest rate to borrow funds if other lending banks have less confidence in it. ”
• If you’re Managing Director/CEO of a Bank, you wouldn’t like to report the higher interest rate of borrowing. Because that means other banks have less confidence in you. Imagine what consequences it can bring?

1. The aam-juntaa would still keep coming to your bank as long as you hire celebrities to do the advertisements.
2. But, The big corporate houses, have wise Chartered Accountants, who understand the meaning of such numbers and its long term consequences. So, CA may advice his CEO to close the company’s bank accounts and deposit money in other banks.
3. Some big Companies may even stop taking loans from you.
4. The price of your shares, go down in the sharemarket, because investors lose faith in your bank.

And with all this mess, the Board of Directors may remove you from your CEO job and hire a new CEO to fix the bank.

What is Barclays?

• Barclays is the name of a British Bank.
• It is the fourth-largest of any bank worldwide (First three banks are: BNP Paribas, Deutsche Bank and HSBC)
• On a side note, if we make list of Top 50 banks of the world according to the cash they’ve, then there is no bank from India.

Anyways, coming back to this Barclays Bank.

• Recall the sub-prime crisis, Barclays, along with many other banks had given loans to plenty of unworthy customers in US, who didnot have the aukaat to repay the loan. Barclay’s money was stuck in USA – around 12 billion dollars worth of toxic assets. So Barclay’s situation was bad, the other rival banks of London, knew it and they didnot have much confidence in this bank.
• But even during this period, Barclay [and other 15 banks in London] had to send daily SMS to BBA Manager so that he could calculate the LIBOR.
• So, Barclays’ CEO Mr.Bob Diamond sent artificially low figures to BBA manager, in order to hide the fact that his bank was in a mess.

Bob Diamond says “whaat an idea sir-ji”

• [recall the concept : if bank X has to pay more interest for borrowing from another banks compared to bank Y, that means Bank X is weaker than Bank Y.]
• It’s not that Bob Diamond himself sends fake SMS from his Nokia 1100, they’d have pretty sophisticted email or software system and dedicated staff for doing all this, but the Barclay staff will not dare to send wrong data to BBA, without the secret consent and approval of Main boss.

It doesn’t mean that Barclays is the only villain in this episode.
Some of the Other 15 banks of London also misreported their borrowing rates, why?

• Because, During the global financial crisis (2007 and afterwards) the RBIs (Central Banks) in developed countries (like UK, France and US) had started giving loans to their nations’ banks at very nominal or close to 0% interest rate in order to boost the economy.
• So the various banks in London, also got cheap loans from RBI of UK (known as Bank of England).
• Now their CEOs had incentive to to quote higher than usual rates of borrowing because if LIBOR went up, then their banks could earn more interest on Libor-linked loans.
• If LIBOR rate was manipulated even by 0.01%, then these banks could make a about a couple of million dollars more in the interest rate charged on home / business loan customers.
• So, Barclays is not the only villain this scam, just like A.Raja is not the only guy in 2G scam.
• Side-Question: if the banks in London are getting cheap loans from their RBI, then Barclays should also have recieved some loans from their RBI @0%, right? yep, but Barclays was in bigger trouble (12 billion dollars) than the amount of money their RBI could lend to fix the mess.
• It is also alleged that Barclay staff also coordinated with staff from other banks to jointly report the false data to BBA. [Because these people had invested in various futures/derivative contracts whose payment depended on LIBOR rate.]

Wrong Data= Wrong Average

• You already know that BBA manager will receive 16 SMS every morning, he’ll remove the top 4 and bottom 4 values and take average of the remaining values and publish that number as “LIBOR” rate for that day.
• If even a single SMS [value] is incorrect, then he’ll get a wrong average [LIBOR].
• In our case, Barclay is reporting lower than usual, while some other banks are reporting higher than usual, so overall the Average (LIBOR) increased.
• So all these years, BBA manager was publishing wrong LIBOR, because he wasn’t getting the right data from Barclays and other banks.
• And because of the Wrong LIBOR rate, the UK and US citizens had to pay higher interest rates on home, student and business loans [because their banks set the home/education/business loans’ interest rates according to LIBOR rate]. Similarly investors in Forex, Commodity etc. market ended up paying more than necessary money for the contracts, because their contracts were linked to LIBOR.

Ref

1. Ila Patnaik, Indian Express : http://www.indianexpress.com/news/smoke-and-numbers/981611/0
2. BBC:
   1. http://www.bbc.co.uk/news/business-18613988
   2. http://www.bbc.co.uk/news/business-18622907
3. New York Times: http://www.nytimes.com/interactive/2012/07/10/business/dealbook/behind-the-libor-scandal.html