Question

Discuss how LIBOR has impacted our economies.

Please add sources if possible

Answer 1

LIBOR is equivalent to the federal funds rate, or the interest rate one bank charges another for a loan. The advent of LIBOR can be traced to 1984, when the British Bankers Association (BBA) sought to add proper trading terms to actively traded markets, such as foreign currency, forward rate agreements and interest rate swaps. LIBOR rates were first used in financial markets in 1986 after test runs were conducted in the previous two years.

Today, LIBOR has reached such stature that the rate is published daily by the BBA at about 11:45am GMT.

For the past several months, financial and business media have extensively reported on the so-called LIBOR scandal. LIBOR, which stands for the London Interbank Offered Rate, is supposed to reflect the average rate that leading banks in London pay for short-term loans and is based on data the banks submit to the British Bankers Association. Several banks are accused of deliberately misreporting their LIBOR submissions, thus affecting the level of LIBOR. Barclays, for example, reached a settlement with both British and American financial regulators after admitting that it had underreported borrowing costs during the 2008 financial crisis, thereby appearing to regulators and the market to be healthier than it actually was.

Deliberately distorted LIBOR submissions may cause several different types of economic harm, and each of these types must be measured in a different way. If investors rely on LIBOR submissions to assess the creditworthiness of a financial institution, fraudulent information may affect the reporting bank’s stock price and the interest rate on its bonds. An event study can measure the effect of fraudulent submissions on stock prices and serve as the basis for quantifying harm to stockholders. Similarly, if bondholders are undercompensated for the risk of lending to the bank, their losses may be estimated from differences between the interest rate they received and the rate that the bank would have paid had it reported correct information.

Economic harm also stems from the indirect effect that a false submission has on financial instruments that have rates based on LIBOR. These instruments include commercial loans (e.g., floating rate loans), consumer loans (e.g., credit card balances and variable rate mortgages), and numerous derivatives (e.g., interest rate futures and interest rate swaps). Several recent lawsuits deal with these aspects of purported interest rate manipulation.

Traditional borrowers may be harmed by manipulation that increases LIBOR. In a recent class action lawsuit filed in New York against several major banks, homeowners have claimed that the interest rates they pay on variable-rate mortgages have been inflated due to LIBOR manipulation. In particular, the suit alleges that traders at some of the major banks had incentives to alter LIBOR on certain dates used as benchmarks for resetting variable interest rate loans, especially for less-than-prime mortgages sold prior to the financial crisis. Economic harm in these cases can be measured by the excess payments borrowers made over what they would have paid had the LIBOR not been manipulated.

Manipulation of LIBOR also harms investors in certain derivative financial instruments, some of which are especially sensitive to changes in LIBOR. Investors seeking protection from interest rate spikes (or simply betting that interest rates would rise) entered into derivative contracts that paid off if LIBOR rates were high. An artificially low LIBOR may cause significant economic losses to such investors. A recent complaint by hedge funds involves losses from futures contracts that failed to pay off because of artificially low LIBOR rates.

Similar complaints arise in the market for interest rate swaps. In the typical interest rate swap, a party swaps fixed- for floating-rate obligations, where the floating rate is based on LIBOR. If the LIBOR is artificially understated, then the counterparty receiving floating-rate cash flows gets lower payments than it would if reported LIBOR were higher.

State and local government agencies in the United States have been significant users of interest rate swaps. In the typical arrangement, an agency issues bonds with floating-rate obligations, in particular so-called auction-rate securities, and then hedges its variable-rate exposure by entering into an interest rate swap pegged to LIBOR (with a bank or other financial institution as counterparty). While the fixed-rate cash flows (i.e., what the agency owes the bank) are unaffected by changes in LIBOR, the floating-rate cash flows (i.e., what the agency receives after the swap) fluctuate with LIBOR. With artificially low LIBOR rates, the variable payments received from the swaps would fall short of the original obligations created by the auction-rate securities, rendering the swaps ineffective as hedges. Not surprisingly, states and municipalities were among the first entities to claim losses associated with artificially low LIBOR rates.

Beyond the direct and indirect effects described above, LIBOR manipulation can cause other economic distortions that may be far more difficult to quantify. One fundamental building block of stable financial markets is the proposition that prices reflect underlying value. Interest rates are one such price and are assumed to reflect risk accurately. If these interest rates are subject to manipulation, however, then financial markets may not properly reflect the price of such risks. In the Barclays settlement cited above, Barclays acknowledged reporting incorrect financial information to appear healthier, and less risky, to the market and to regulators. Therefore, contracts it entered into with other banks were most likely mispriced. On a macro level, regulatory agencies, acting on the belief that LIBOR was properly reported, may have incorrectly assessed the risks of both individual financial institutions and financial markets more broadly. In an environment in which risks can propagate in unexpected ways, such misreporting can affect the fundamental stability and health of the financial system.