The Libor cheating scandal shows there is still something rotten in the state of banking.
What if I told you that Wall Street banks set the most important interest rate in the world by telling us what they think their borrowing costs are? You'd probably say that sounds like a bad idea. Why wouldn't they just lie? And collude?
Shock of the century: That's exactly what happened.
The big revelation -- and I use that term lightly -- is that Barclays deliberately manipulated Libor from 2005 through 2009. It's already cost the Barclays Chairman, CEO, and COO their jobs -- and they're trying to drag Bank of England (BOE) officials down with them. But the rot likely doesn't end there. A handful of other big banks -- including JPMorgan, Citibank, UBS, Royal Bank of Scotland, HSBC, Credit Suisse and Deutsche Bank -- are under investigation as well.
Okay, obvious question time. What is Libor, why does it matter, and what does this mean? Let's tackle these in turn.
Libor -- which stands for the London Interbank Offered Rate -- is supposed to be the interest rate banks can borrow for from each other on an unsecured basis. In other words, it's how much a bank has to pay to get a loan from another bank. There are different Libor rates for different currencies and over different time frames, but they're all set the same way. Each morning a panel of banks tells the British Banking Association (BBA) what they think they could borrow for. The BBA throws out the high and low answers, and then averages the middle. Voilà, Libor.
There are roughly $360 trillion reasons you should care about this. That's the total value of contracts that use Libor as a reference rate. Everything from mortgages to student loans and all sorts of derivatives depend on Libor. When it comes to loans, their interest rates change with Libor; when it comes to derivatives, their payouts change with Libor. But there's another big reason to care about Libor -- you might say it's worth another $700 billion or so. (Remember, that was the original size of TARP). Libor should tell us about the health of the financial system. Banks can't exist without confidence. If banks don't have the confidence to lend to each other, banks won't exist -- as was nearly the case in 2008.
There's an obvious flaw with Libor. The banks have to be honest. Barclays wasn't. From 2005 to 2007, Barclays manipulated its Libor submissions to benefit its traders. There are emails -- oh so many emails -- that prove this. If you like your fraud colored with sentences like "Done...for you, big boy" or "Dude, I owe you big time! Come over one day after work and I'm opening a bottle of Bollinger," then I highly recommend you click the link above. The basic idea was simple. Sometimes Barclays traders needed Libor to be higher or lower for their bets to pay off. So they asked for their bank submitter to help them out -- and the bank submitters did!
Things changed in late 2007. That's when the credit crunch hit. Banks started to not trust each other. And so banks began to systematically understate Libor. Again, the basic idea was simple. Banks wanted to look healthier than they actually were. So they said they could borrow for less than they could. But there was a problem. These were fairly obvious lies -- obvious enough that the financial press could figure it out from publicly available information. Gillian Tett of the Financial Times noticed that Libor was not what it should have been back in September 2007. Carrick Mollenkamp and Mark Whitehouse of the Wall Street Journal came out with a study in May 2008 that showed that banks were indeed low-balling Libor estimates.
But there was a perverse peer pressure to it all. Banks that didn't cheat looked riskier to investors because their Libor numbers were higher. Barclays actually seems to have been one of the last big banks to start lowballing their Libor numbers -- at least in 2008. Up through the end of October, Barclays' Libor submissions were routinely on the high end of the spectrum. Then they were less so. Ex-CEO Bob Diamond has offered up a self-serving story that the BOE basically told him to reduce their estimates -- which, while plausible, lacks any corroboration. As Felix Salmon pointed out, it's just as plausible that the BOE was just doing its job as a regulator, and things were so rotten in the state of Barclays that they interpreted that as an invitation to start lying again. Regardless, it seems like many, many other banks were even more in on the scam than Barclays during the height of the crisis. More heads will come a-rolling.
It sounds silly, but the biggest victim in all this is the financial system itself. It's unlikely this manipulation really affected ordinary borrowers. The cheating wasn't big enough to push interest rates up much, if at all, for borrowers with loans tied to Libor. And cheating of the lowballing variety actually helped borrowers. But that doesn't mean this manipulation was irrelevant. Wholesale lying is a problem in an industry that relies on trust. The big banks have taken whatever shreds of credibility they had left and lit them on fire. If Barclays will lie about something as fundamental as Libor to profit on its trades, how can clients trust them on anything?
This is an existential crisis for the big banks. Do they serve clients or their own balance sheets? Haha, forget I asked that. The answer is obvious. What's less obvious is why anyone who doesn't work at a bank would think the status quo is acceptable.
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Matthew O'Brien is a former senior associate editor at The Atlantic.