Revelations that bankers have been manipulating the world’s most important benchmark rate – LIBOR – has fed media attention to the burgeoning scandal.
But along with this media attention has come confusion about the nature of the scandal—in particular, the idea that the common man lost out to the big bad bankers, and the world’s central bankers looked the other way.
This may not be false per se, but such an oversimplification ignores the fact that there are two completely different moments of this crisis, with very different implications:
In the period before late 2007 and the start of the financial crisis, bankers appear to have been adjusting the rate for their own personal gain. We have showed that Barclays would have made more than $2 million on a trade by adjusting the rate by one basis point on one day back in March 2006, though their plan did not appear to work.
Such violations were uncovered during a U.K. investigation of Barclays, and in a testimony in front of members of the U.S. House of Representative, Bernanke said that he did not know of such rigging for profit until much later on.
Losses and gains on manipulations of these contracts would mostly have affected traders, as the common man would have felt little effect from minute alterations in the rate. True, banks’ clients could have had contracts large enough to benefit or lose out from these manipulations, however it’s important to note that a) these contracts were mostly used to hedge against interest rate changes, not as a primary investment, and b) the vast majority of attempts to manipulate LIBOR (at least the ones cited documents about Barclays) failed or had only a minute impact on the rate.
Either way, there’s little doubt that such practices were wrong, and undermine faith in bankers.
LIBOR manipulationIn the lead up to and during the financial crisis, it is clear that bankers manipulated their data on LIBOR in order to signal to markets that they were not having money problems. As credit tightened, the markets became prejudiced against banks that did not artificially lower their LIBOR submissions. In a phone exchange between a trader at Barclays and an employee at the Fed, the trader alleged that Barclays had been forced to bring down its rates in order to prevent losses in share price, and that the banks with the lowest submitted rates were actually the ones paying the most to borrow.
The Federal Reserve Bank of New York did figure out that banks were distorting their rates for this purpose, and addressed this problem in emails to the Bank of England. It is likely that traders made money off of this, but the volatility present in the rate at this moment will make any distortions here hard to uncover.
That said, this problem was a consequence of the financial crisis and stress in markets. Although the Fed noted that this was a problem that could eventually undermine faith in this benchmark rate, such concerns took a backseat to saving the global financial system as banks neared the brink of collapse. For a complete explanation of why central banks did nothing, read this >
Further, during this moment lower LIBOR rates helped rather than hurt the common man. Lower LIBOR rates allowed banks to keep lending and consumers to keep borrowing—two activities which are absolutely essential to a functioning economy. So if you borrowed money during this period or had to deal with any floating interest rate, you probably lucked out from LIBOR manipulation during the crisis. It’s no surprise, then, that central banks were willing to look the other way for a while.
It’s true that any purposeful distortion of LIBOR undermines credibility in the rate and in the system, but it’s important to distinguish between two different moments in this scandal—one of which may not really be such a scandal at all.