Keynesian Spirits

A Scam at the Heart of a £350 Trillion Market

Barclays Bank has been charged by Britain’s rejuvenated financial regulator, the Financial Services Authority, as well as the US regulator, Commodities Futures Trading Commission, for manipulating a key interest rate – the London Interbank Borrowing Rate (LIBOR).

This manipulation began around 2005 and continued for around five years. LIBOR indicates an average of borrowing rates for banks in all top currencies, and is used as the benchmark for financial contracts and interest rates around the world, which is a market worth £350 trillion.

This is how LIBOR is calculated: the British Bankers’ Association (BBA) asks each bank what rate it expects to pay to borrow from other banks for relatively short time periods – from overnight loans to 12 months in a range of currencies. It is important to note that such short-term borrowing was the primary source of funding for a lot of banks. Before the financial crisis, this rate used to be quite low, because banks didn’t see much risk in lending to each other as they were all profitable, and the markets were functioning perfectly. However, when the subprime crisis exploded, it became clear that many of the assets that banks held on their balance sheets may be worth much less than thought, all banks panicked, LIBOR shot up, and banks stopped lending to each other. Nobody was willing to trust anyone. How could they know that the bank they were lending to was fundamentally sound, and wouldn’t be bankrupt in the future?

It was in this environment that Barclays, and other involved banks, made the most by manipulating the rate. It was certainly used to boost profits, but more importantly, the banks manipulated to rate and pushed it lower during the financial crisis. This was done to convey the false signal that the banks were sound, that their borrowing costs weren’t too high, and that they didn’t need any help. Thus, Barclays was able to dupe foreign investors, mostly cash rich, but risk-averse sovereign funds, during the panicky period of 2008. Barclays, unlike RBS, said no to UK government funding, and instead asked sovereign funds to invest in the bank.

For such an important interest rate to be calculated in such a manner seems cavalier. The calculations are done in such a manner that outliers are eliminated so that one bank cannot really influence the rate, but in this episode, while only Barclays has been fined yet on this matter, others like the Royal Bank of Scotland, UBS, Bank of America, Citigroup and a dozen other banks (spanning 3 continents) are being investigated as well. Hence, this was most probably an industry-wide practice, and wasn’t solely limited to Barclays.

You can see the flaw in the above method: the BBA asks banks to supply them with their borrowing rate. What happened at Barclays was that its traders had some positions in the market – they had bought an asset, or promised to purchase it, or they had some other financial position, and a change in this crucial interest rate would benefit their trades. Thus, the traders colluded with the treasury department (which sends this information to the BBA) to supply incorrect rates and thus manipulate them. It must be noted that normally there is supposed to be no communication whatsoever between these two parties.

Here are some useful readings on this issue:

Q&A by FT 1

Q&A by FT 2

BBC’s excellent Paul Mason with a clear, detailed post on Barclays’ manipulative acts

A primer on financial products