Libor Fixing

Barclays has been fined heavily by regulators in the USA and the UK for manipulating Libor fixings, and other banks are under investigation.  I've read a fair bit about how shocking the disclosures have been: I'll seek to clarify here what is and what isn't a surprise.

Libor stands for the London Interbank Offered Rate.  It is supposed to be "The rate at which an individual contributor panel bank could borrow funds, were it to do so by asking for and then accepting interbank offers in reasonable market size, just prior to 11.00am London time".  It's produced by the BBA (British Bankers' Association) for ten major currencies with fifteen maturities in each, from overnight to one year. It's calculated every business day by asking each member of a panel of banks what rate it could borrow at, eliminating the upper and lower quartiles, and averaging the others.  There are currently 18 members of the largest panel (for US dollar rates) and six for the two smallest (for Swedish Krona and Danish Krone), so a bad quote from one member of the panel will have a small but not zero effect on the calculated rate unless both the bad and the true quote fall in the same extreme quartile.

Bob Diamond, the Barclays Chief Executive, who seems to have been relaxing with his money while the wrongs were being done, has written to the chairman of the House of Commons Treasury Select Committee to explain in outline what happened.  There were two sorts of manipulation: the first went on between 2005 or earlier (the investigation goes back to 2005) and 2008, and involved Barclays' submissions to the BBA being adjusted to suit the position of the trading book - if the book was a net payer of a particular rate, Barclays would submit a low quote, and vice versa.  This is truly shocking, the more so in that the traders involved seemed to have been utterly brazen in the emails they sent about it - there seems to have been no sense that they were doing anything improper.  Diamond's excuse is that only relatively junior traders were involved in this abuse, but it's elementary that the BBA submission process should have been entirely isolated from trading considerations, and it's a management failing that this was not the case.

The second manipulation occurred during the banking crisis between 2007 and 2009, when Barclays submitted artificially low quotes in order not to stand out as a poor credit risk.  Diamond's excuse is that they did it because the other banks were doing it and they would have looked bad by comparison if they hadn't.

Whatever the truth of the excuse, no one who's been paying attention, and certainly not the British Chancellor of the Exchequer, should be surprised to learn that banks were quoting artificially low rates.  The Wall Street Journal published reports to that effect in April and May 2008, following a cautious investigation by the Bank for International Settlements (pp59-72 here) which found "Little evidence of manipulation".
The clearest evidence that Libor rates have been unrealistic comes from cross-currency basis swap spreads.  These swaps allow one to synthesize a floating-rate loan in one currency from a floating-rate loan in another currency.  If banks could borrow freely at Libor in both currencies, the spreads would be close to zero.  But here's a chart I created in 2009 for a conference presentation that touched on the subject:

The red line is the cost of borrowing in Euros at the Euribor rate - a rate similar to Libor but calculated by the European Banking Federation.  The green line is the cost of borrowing in dollars and using a basis swap to convert the loan into euros.  The separation between the two lines, which appears in August 2007 and spikes in November 2008 tells us that one or both of the rates is wrong - in fact it's the dollar rate which is artificially low.  If banks could really have borrowed at dollar Libor they would have done that in preference to borrowing at Euribor, but they couldn't.  It may be relevant that the Euribor panel is asked a slightly different question - what rate do they think one bank could borrow from another at, rather than what rate could they themselves borrow at.  So it is less embarrassing for them to quote a relatively high rate.

Who has been damaged by all this?  Diamond claims about the first manipulation that "The interventions in question were typically on the short term one and three month rates relevant to the wholesale markets and not the longer term rates used to set, for example, retail mortgages". I suspect that's inaccurate. Only a small proportion of mortgages use Libor contractually to set their rates, but my brief investigation suggests that in the UK the ones there are mostly use three-month Libor.  All the same, my guess is that most mortgage holders will have profited overall from the manipulations, since they kept rates artificially low during the banking crisis.  On the other side, any institution which was issuing Libor-based mortgages during 2008 should have been aware of the problems with the numbers and ought to have widened their spreads to compensate.  Thus the people with a genuine grievance ought for the most part to be the Barclays' market counterparties who lost out when the fixings were manipulated to suit Barclays' trading book.  I don't know how eager they'll be to sue, but I'm sure there will be plenty of lawyers with the whiff of money in their nostrils to encourage anyone with any sort of a claim to have a go.

Update: I recommend this post by Frances Coppola, which includes quotes from the FSA report setting out exactly what Barclays was up to.