Libor and the Public Interest

Are you ready for yet another global banking scandal? Last week, the Chief Executive Officer of the British banking giant Barclays resigned in disgrace over the news that his organization had participated in a mammoth illegal scheme to fraudulently manipulate the Libor interest rate.

Libor? It’s the London Interbank Offered Rate, an interest rate that dominates the world’s variable debt markets. If you have a variable interest loan, there’s a good chance that your rate (and thus your payments) fluctuate on a daily, weekly, or monthly basis in accordance with the fluctuations of the Libor rate.

Any bank that possesses the power to manipulate the rate can make a fortune through a variety of methods. It could sell low interest loans to other banks shortly before a rate increase, for instance, or it could buy high interest loans from other banks shortly before a rate decrease.

Based on the preliminary findings of the unfolding investigation, many other global banks may be guilty of rate manipulation as well. And sadly, industry regulators have apparently been able to access evidence of the manipulations for several years, but either failed to notice the warning signs or failed to respond to them.

Hiding In Plain Sight

According to City A.M., a London newspaper and web site that covers financial and business news, four researchers (including Michael Kraten, one of the co-authors of this blog) raised questions about the possibility of manipulation in a study that was first presented in scientific circles four years ago.

Their manuscript was peer reviewed on two occasions, first prior to a presentation at a conference meeting of the Public Interest Section of the American Accounting Association in 2010, and then prior to its publication in the Journal of Banking and Finance in January of this year.

The study was also briefly mentioned in the Economist in April of this year, but did not receive widespread attention from business news organizations like CNBC and the Financial Times until this past week. City A.M. thus described the alleged perpetrators of the manipulation as “hiding in plain sight.”

Relying On The BBA

So how did the banks manipulate Libor? The institutions arranged for their trade association, the British Bankers’ Association (BBA), to collect their rate quotations each day. The BBA then ignored the highest and lowest quotations, computed simple averages of the remaining quotations, and announced the statistics as the Libor rates.

The banks claimed that their quotations reflected estimates of their own true borrowing costs. But no government regulator ever asked the banks to produce evidence that their quotations were actually based on real transactions. And their own trade association never challenged them to do so either.

Nevertheless, the BBA did make the banks’ original quotations available for public inspection, and thus the four researchers were able to build upon a previous Wall Street Journal analysis to identify statistical anomalies.

What anomalies? The quotations did not appear to move in synchronization with other measurements of bank borrowing costs that were available for analysis. And perhaps more disturbingly, normal patterns of random fluctuation were not evident in the trends of the quotations during certain noteworthy periods of time.

Some Critical Suggestions

Some critics have suggested that the Libor rate calculation process should be taken away from the BBA and given to an independent, objective entity. Others have suggested that the BBA (or another entity) should aggregate actual transaction information and not rely on “estimates” supplied by banks.

These are certainly reasonable suggestions. But if the banks were willing to submit fraudulent rate quotations to their own trade association, why would they not be willing to do so to some other entity as well?

And as JP Morgan Chase demonstrated with its own defense of a recent speculative transaction that was designed to meet the legal definition of a defensive hedge, the global banks are undoubtedly capable of engineering complex transactions that can produce “actual” data in accordance with any regulation.

The Public Interest

There is one suggestion, however, that could be implemented easily in order to protect the public interest. The Libor rate information could be subjected to audits by independent certified public accountants.

In the United States, such audits would fall under the jurisdiction of the Public Company Accounting Oversight Board (i.e. the PCAOB). The Board’s standards for attest engagements covers “historical … financial information (and) … analyses” in its AT Section 101, Paragraph .07.

Can the public trust the CPAs to audit the bankers? As well as the government regulators to oversee the CPAs? Although an audit requirement may not be sufficient to eliminate any possibility of a future scandal, it may be difficult to feel confident about any self-reported bank data until the statistics undergo professional audit activities.

In other words, even though an audit requirement for Libor may not represent the “last word” in developing a system of reporting that supports the public interest, it may nevertheless represent a perfectly reasonable place to start.

End Note:

On Friday, 13 July, Brian Mairs of the BBA provided the following comment to our publisher: British Bankers’ Association here. Regarding your story on LIBOR on 8 July, we need to make an important factual correction: the BBA does not set LIBOR. The LIBOR benchmarks are calculated daily from submissions made to Thomson Reuters: it publishes the benchmarks daily, along with all of the submissions from individual banks which are used to calculate it.

Although we never stated that the BBA “sets” Libor, we agree with the remainder of Brian’s comment. The Libor benchmarks are indeed derived from submissions that originate from the banks and not from the BBA itself. And Thomson Reuters does indeed provide a data compilation service.

We are allowing our column (above) to remain in its original form, and we ask our readers to decide for themselves whether Brian’s comment is a “factual correction” (as Brian refers to it) or an elaboration (as is our belief). Nevertheless, we do concur with his description of the process, and we stand by our suggestion.