LIBOR and its mechanism:

LIBOR- the London Interbank Offered Rate is a benchmark interest rate representing the average that London banks pay to each other to borrow money in short term.  It also functions as a primary benchmark, along with EURIBOR, for short term interest rates around the world. It consists of a panel of 18 banks which submit estimated interbank interest rates based on various currencies of different maturity periods. In fact, rates are calculated for 10 different currencies and 15 borrowing periods ranging from overnight to one year and are published daily at 11:30 am (London time) by Thomson Reuters. It is a practice to eliminate the 4 estimated/real ceiling and the floor rates, submitted by the empanelled banks, and the balance 10 submitted rates are averaged to determine the bench marked LIBOR. 

Importance of LIBOR:

It is used as a benchmark rate in standard derivative and loan documents. Businesses, mortgage lenders and credit card agencies use the standard rates to determine their own interest rates. There are trillions of derivative contracts and financial instruments that are linked to LIBOR across the globe, which shows the significance and importance attached to it.

LIBOR is important because it is referenced by nearly $800 trillion in global financial instruments, including corporate debt, mortgages, student loans, interest rate swaps, and other derivatives. The importance of LIBOR can be further gauged from the fact that rate of interest used in all financial calculations are based on ‘Capital Allocation Pricing Model’.  The fundamental principle of this model assumes that interest rate for borrowing on risky ventures will seek for compensation above the ‘Risk Free Rate’. An investor will demand a higher spread when the security, investment or a portfolio is riskier.  It is believed, across the world, that the LIBOR is a risk free rate and the spread for individual loans are based on this rate.   Apart from this, LIBOR acts as a barometer to determine the overall health of the banking industry at large.  

What went wrong?

Bankers and market participants at a point in time felt that there was something amiss in the way rates were being set by the empanelled banks. The chronology of events that unfolded on the basis of such a feeling, confirmed the concerns of users and participants of LIBOR.

2007 (November): Concerns were expressed to British Bankers Association that LIBOR was not representing the true borrowing rates among the empanelled banks;

2008 (May): Wall Street Journal published an analysis indicating that there is a variance in reporting borrowing costs, between different market measures and banks;

2011 (March): Investigations were started in US agaist the LIBOR setting banks, for manipulating the declared rates.

It was alleged by the regulators that rates have been manipulated up or down to benefit bank’s trading position.  Banks have attempted to influence not only rates submitted by them but there have been attempts to rig rates of other empanelled banks as well.  Also, the banks have intentionally lowered the LIBOR rates to impress that their financial positions were better off than what was actually there.  It is common understanding, that lower the borrowing rate lower would be the credit risk.  Hence, a bank submitting higher rates, than other banks in the panel, would give the impression that it had a higher credit risk than among the peers.  Therefore all out attempts were made to manipulate rates to ward of evils arising out of financial crisis prevailing in the economic environment.

Action and impact:

Barclays has gone on record to say that it had manipulated LIBOR rates since 2005 and through 2009 to reflect a better liquidity position and to benefit its interest-rate derivative positions.  A trader or a colleague of UBS Securities Japan manipulated the Yen LIBOR, starting from November 2006 on at least 335 of 738 trading days. It has been estimated that even a 0.01 percent movement in LIBOR fixing on any date would generate a profit of around $2million.  Investigators have established that RBS traders colluded with other traders to fix LIBOR rates between 2006 and 2010.  It helped other traders to invest in interest trade swaps that were influenced by the LIBOR rates. All the three empanelled banks were fined, and settlements were reached with US/UK regulators and US Department of Justice as follows:

 
Apart from the above, there are ongoing investigations trying to establish and fine other defaulting banks, criminal investigations against individuals and competition investigations, which are likely to conclude in 2014.  There are a number of putative antitrust class action suits against various banks which has created a contingent situation for them, not knowing when it will end.  The liabilities could run into billions of dollars if investigations are taken to their logical end.  Probably this scandal must be much larger than Madoff Ponzi Scheme or the Enron debacle, for it is all pervasive, and many seem to have lost without realizing it.

Regulatory Mechanism:

Until the scandal broke out, there were no yardsticks to measure the quality of submissions made by the banks in the panel. It was for the bank management to ensure that there was no foul play in declaring the rates and it had to ensure a robust process for quality submission of rates from time to time. Since the rates reflected the status and financial health in the economy, banks were supposed to report lower rates if the confidence in the economic and financial system was high and higher rates if the degree of confidence was lower.  There was no mechanism in the system to hold any person responsible for manipulation of rates, as the then existing regulation did not provide for adequate safeguards.  They were not regulated activities under Financial Services and Market Act, 2000 (FSMA) and therefore the Financial Services Authority (FSA) could take no action against the bank or the officials. In the absence of specific monitoring of, and regulation for, the LIBOR setting banks, it was easy for them to rig the rates to their advantage.

Aftermath of the scandal:

In view of the weaknesses that existed, which allowed empanelled banks to manipulate the LIBOR rates, and as an aftermath of the scandal, a review was undertaken under the authority of George Osborne, the Chancellor of the Exchequer (UK), by engaging the services of Martin Wheatley, CEO designate of Financial Conduct Authority (FCA) in July 2012.  Consequent to the recommendations in the review, LIBOR code of conduct has been put into place from 12^th July 2013, which has been approved by the Interim Libor Oversight Committee, and confirmed as Industry Guidance by FCA.

The regulation of benchmark setting and introduction of a Code of Conduct, for the contributing banks are the key elements in bringing formalization and professionalism into the process. Legislation (The Financial Services and Markets Act 2000 (Regulated Activities) (Amendment) Order 2013) has been recently introduced to regulate benchmark submission and administration. FCA is the competent authority for regulation and supervision of benchmarks.  Knowingly or deliberately making false or misleading statements in relation to benchmark-settings has been made a criminal offence.  LIBOR code has been established to provide a framework within which contributing banks can operate and to assist users of LIBOR rates when deciding whether LIBOR is an appropriate rate to use in contracts.

BBA LIBOR Limited (BBAL), alongside Thomson Reuters, is the benchmark administrator, which has developed a code for the benchmark setters and the participating banks.  Among other things it broadly includes:

It is interesting to note that that the Danish, Swedish, Canadian, Australian and New Zealand LIBOR rates have been terminated.  Earlier there were 150 LIBOR rates for averaging (10 currencies of 15 maturities each), whereas now there are 35 rates for averaging from 5 currencies and 7 maturities, being quoted each day from the end of July 2013. The intention of doing this is to peg rates from real trades and avoid speculation or manipulation in rates.  Further, each bank has to have a responsible official who has to certify that there is no wrong doing and maintain such documents and records that will be necessary for the regulator to scrutinize and subject them to audit.  It is proposed that in early 2014, NYSE Euronext Administration Limited (a London based UK registered company, regulated by FCA) will take over the administration of LIBOR from British Bankers Association.

Functions of regulation:

A primary function of regulation of financial markets is to uncover and discipline misconduct.  In this globalized world, failure of financial markets in any corner of the globe will have repercussions all over and the ramifications are never fathomable and require concerted efforts of the regulators to avoid systemic problems. While trying to enforce discipline through fines, penalties and imprisonments on institutions and their employees, it will create a reputational risk which of course would be a deterrent for unruly behaviors.

Lessons from the scandal:

An important lesson that the scandal event teaches us is that so long as any economic process are a financial instrument is opaque and complex, and less amenable to general population, it can be safely assumed that they are pyramid schemes. If it is allowed to go too far, obviously it is going to hurt people in the lower economic strata, creating a systemic problem, the evils of which will remain in the system for unbearable times both for the governments and public at large.  In a globalized economy the waves will spread and linger around even for sections or classes of public who are not responsible for the event or the problem.    

Any self-serving attitudes or actions, at the cost of social damage, are not going to sustain for long times to come.  Institutions which have grown and are growing, affecting the mass, have to keep polishing their methods and processes to ensure that their reputation is not sullied, which has to necessarily come at a cost.  But the long term benefits will necessarily outweigh the initial cost and societal values are built on such fiduciary mechanisms.  Any action that has an ulterior motive of increasing profits through questionable means and questionable integrity, at the cost of gullible public, indicates an institutional failure in managing conflicts and conflict of interest.  It is here that governance has to play an effective role. Unless it is identified and felt that financial services are meant for economic good and are subservient to the real economy, speculations and manipulations can raise its ugly hood creating disasters to the real economy. It the responsibility of the regulators and professionals not to abet such acts even if it means loss of lucrative offers.

Another important lesson that is offered by the LIBOR scandal is the absence of reliable and adequate board oversight and laxity in internal controls.  After all, the regulators get hint of mismanagement or manipulation after sufficient damage has already been done. The shareholders, who are the owners, have to take proactive positions to insist that the board of directors lay down stringent governance and control procedures in the management of the affairs of the entities. It is the shareholders who lose, if the institutions fail or have reputational loss in public.  Shareholders cannot expect capital appreciation, or returns by way of dividends, if the boards of companies have no men of integrity and thoughts of public good.

Role of the auditors:

To aid company’s efforts, of good corporate governance, auditors too play an important role in ensuring that controls are in place and they are in fact working on expected lines. Auditors have to understand that their roles are way beyond regulatory rules, and a fair value assessment of events is the hallmark of a person with integrity and ethics.  Can the professionals take up this call to aid institutions, shareholders and regulators in the same breath?  Earnest attempt may gradually cleanse the rot in the system which of course comes at the cost of sacrificing many comforts.

Poor cultural and leadership issues, conflict of interests, thoughts of private comfort against public good, speed money and effortless earnings, false sense of insecurity resulting in amassing wealth beyond requirements, etc., are some of cultural ethos of this country, which often puts a professional into quandary.  Unless he is trained to resolve this conflict in favor of public good, he will continue to remain one among the normal without creating any impact either for himself or for the real economy.  Any amount of regulation would be insufficient to deal with manipulative tendencies in the economy, and a constant vigil through governance and audit, which are complimentary measures to thwart this evil, has to be put into place.

Agenda for reforms:

The need, and the mechanism of LIBOR rate setting, cannot be wished away but needs to be reformed to establish absolute faith in the process.  Institutional governance and regulatory framework have to play their effective roles, as human skewed tendencies cannot be ignored.  Establishment of rules and procedures within the institutional framework so as dovetail into the broader regulatory framework needs men of integrity and grit.  The whole universe rests on such principles irrespective of the nature of activity that is undertaken.  Auditors too cannot be an exception to this rule as they are the conscience keepers in this world and the responsibility has to be assumed on account of the enormous faith that society puts on them.

BY K S RAVI, B.Sc, F.C.A