Libor’s Trillion-Dollar Question
The global investigation into the manipulation of Libor has so far done a good job of exposing how bankers corrupted one of the world’s most important financial indicators. Now authorities need to take a giant step further: Make banks release the data needed to determine how much damage was done and who should bear the most responsibility.
For those still not familiar with the London interbank offered rate, it’s an array of benchmarks designed to provide an objective assessment of banks’ borrowing costs -- information that is used to set the payments on hundreds of trillions of dollars in loans, securities and derivatives worldwide. The rates are calculated by asking banks, every workday morning in London, how much they would pay to borrow money in 10 currencies and at 15 time periods, from overnight to a year.
Investigators are focusing on two kinds of manipulation. In one, bankers submitted false data to push Libor in a direction that would benefit their own traders. In the other, bankers intentionally lowered the reported rates, which are published daily, to make their institutions’ financial positions look better than they really were. In June, for example, Barclays Plc paid about $450 million in fines after confessing that, during the 2008 financial crisis, it lowered its quotes below its true borrowing rates to keep them in line with those of other banks, which Barclays thought were fudging even more.
How long the lying went on, and how systematic it was, matters a lot. If, for example, underreporting caused Libor to be artificially depressed by 0.1 percentage point for only a few months, payments on more than $300 trillion in mortgages, corporate bonds and derivatives tied to the benchmark might have fallen short by about $75 billion or so. If the problem lasted a few years, the shortfall could be close to $1 trillion.
Such manipulation would represent a big gift to payers of Libor, such as financially stretched U.S. homeowners whose interest costs on floating-rate mortgages would have been lower. But for bond investors, municipalities, hedge funds and others on the receiving end of Libor, it would mean major losses. Many are already trying to recoup suspected underpayments through litigation.
How much Libor was off, then, could be a trillion-dollar question. So far, researchers have managed only partial estimates. A 2008 Wall Street Journal analysis suggested that three-month and six-month U.S. dollar Libor -- two of the most widely used rates -- were understated by an average of about a quarter percentage point in the first four months of 2008. A separate study by economists at the New York Federal Reserve used 2007 to 2009 data on interbank loans made through the Fed’s wire-transfer system. It found a smaller average discrepancy, but estimated that dollar Libor rates could have been understated by more than 0.2 percentage point in the two weeks after the bankruptcy of Lehman Brothers Holdings Inc. in September 2008.
It’s worth noting that the pressures on banks to understate their borrowing rates didn’t end with the darkest days of the financial crisis. Concerns about their creditworthiness flared up with the European debt crisis in 2010 and 2011. In June, Moody’s Investors Service downgraded a number of banks that report Libor rates on the grounds that their trading activities could threaten their solvency. Big financial institutions typically borrow $10 or more for every dollar in equity provided by shareholders, so managing the market’s perceptions of their borrowing costs is crucial to their profitability -- and at times to their survival.
To give a more complete picture of the misbehavior, and to establish what share of the compensation burden each Libor- reporting bank should bear, researchers need access to better data on actual borrowing costs. If they could get records of observable transactions, they could produce an independent estimate of how much the banks’ Libor quotes were off on any given day. Such an authoritative benchmark would have many benefits: Plaintiffs, for example, could use it to reach settlements with banks, avoiding legal wrangling that could weigh on the financial sector for years.
Good data, though, are hard to find. The Fed hasn’t made information from its wire-transfer system public. The Libor panel banks, for their part, closely guard information on the interest rates they pay on actual short-term loans. This is an odd habit, given that they are supposedly publishing their borrowing rates in great detail every day for the purpose of calculating Libor. If they’re not lying, there should be no news in the transactions.
It’s up to the authorities investigating Libor to break the information blockade. In the U.S., for example, the Office of Financial Research, set up by the Dodd-Frank financial reform act, has the subpoena power needed to get the data and the brain power required to crunch the numbers. Ideally, it would also make the data public, so independent academics and journalists could check its work.
Shedding light on the extent of Libor manipulation is essential to restoring the market’s integrity. The point of justice, after all, isn’t only to punish the guilty. It’s also to establish the truth, so we can draw the right conclusions, fix what needs fixing and move on.
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