Evidence of Banks Manipulating Important Interest Rate

LIBOR, or the London Inter-Bank Offering Rate, is one of the world’s benchmark interest rates.  It is used in many banking transactions around the world to establish the interest rate to be paid, especially for institutional banks.  In fact, it helps determine interest rates for approximately $10 trillion (!) of loans and, get ready for it, $350 trillion worth of derivatives contracts (!!!).

Currently the U.S. Department of Justice and the Securities and Exchange Commission are investigating whether or not large commercial banks, including Bank of America, Citigroup and Union Bank of Switzerland (UBS), manipulated LIBOR from 2006 through 2008.

LIBOR is determined by sixteen giant banks reporting their borrowing costs to the financial news organization Thomson-Reuters in London.  Then the highest and lowest four interest rates are ignored to rid the data of extreme outliers.  Lastly, the middle eight banks’ interest rates are averaged together.

Because there are so many banks reporting their rates, that outliers are cast out, and that the middle quartiles are averaged, it would be difficult to manipulate LIBOR.  However, in 2008, when the financial crisis was at its peak and individual banks had wildly different risk profiles and hence, interest rates, LIBOR was oddly consistent.

A Wall Street Journal study showed that average LIBOR was 3.18% in the first four months of 2008.  Yet, the various rates reported by the 16 banks only fluctuated by a maximum 0.06%.  In finance parlance, that range was only 6 basis points.  Yeah, right!

In other words, LIBOR was trading in a bank around that 3.18% of only 1.8% either up or down.  To put this into perspective.  Imagine in your own neighborhood you took your mortgage interest rate and those of 15 other neighbors, threw out the four highest and lowest, then averaged the middle eight.  Then imagine that you found that the calculation resulted in an average mortgage interest rate of 6.25%, but that the range was only between 6.19% and 6.31%.

I think you would be shocked.  Especially if some of your neighbors’ homes were dilapidated, run down, or you knew that the owners had been unemployed for awhile.  Essentially these 16 large commercial banks were reporting in the midst of the financial crisis that there were no differences between them.  I find this incredible.  And now you know why these banks are being investigated.

You might make the argument that had the banks reported wildly differing rates that it might have thrown the financial markets into an even bigger panic and meltdown.  You would probably be right.  However, who is to say that they haven’t been colluding for many years, including during times when there was no panic?  That kind of a lie creates distortions of information about the relative differences in the solvency of individual banks.  In turn, that leads to a misunderstanding on the part of market participants, both buyers and sellers, when they are examining investments.  Finally, that leads to poor choices and critical investment losses.

Capitalism relies on honest dealing and good information in order to function well.  In short, honesty is always in season!

I will continue to track this story, because it is just more fuel for my continuing criticisms of capitalism as practiced by these powerful institutions.

Jason