Another financial scandal means it's time for another impromptu primer on the technicalities of banking—and the astonishing chutzpah of bankers.
In this case, it appears that traders at Barclays and possibly other banks manipulated a key interest rate between 2005 and 2009, to help enhance the profitability of their trades. For once, a top banking official has paid a price. Former Barclays CEO Bob Diamond has resigned and forfeited $31 million worth of bonuses in a settlement with the bank. It still isn't clear if Barclays broke any laws or if authorities will press charges.
But the evidence is mounting that traders, perhaps even with the tacit approval of regulators, were able to force down the London Interbank Offered Rate, otherwise known as Libor. Most consumers pay no attention to Libor, yet it affects millions of bank customers directly and indirectly. If bankers were indeed able to manipulate the rate, it may be the most shocking example yet of their ability to exploit the basic machinery of the global financial system for their own gain.
Libor is a measure of the interest rates that global banks charge each other for short-term borrowing, without any guarantees against default, such as those offered in the United States by the FDIC. It's monitored by government agencies, such as the Federal Reserve and the U.K.'s Financial Services Authority, but it isn't regulated by anybody.
There are several Libor rates, reflecting the interest paid on short-term loans ranging in duration from one day to one year. In effect, they represent an average of the real-world rates banks are actually paying to borrow. Ordinarily, Libor rates track other interest rates very closely, since there's usually little or no risk that banks lending to each other will default on their loans.
But during times of economic stress, such as the 2008 financial crisis, Libor is a first-line indicator of rising danger. From 2004 to the middle of 2008, for example, Libor rates for loans of various duration rose and fell in almost exact proportion to changes in the Federal Reserve's short-term interest rates. But starting in Sept. 2008, there was a sharp divergence. The Fed continued to cut its own rates, as the financial crisis intensified. But Libor rates skyrocketed. That indicated that banks were suddenly very nervous about getting back any money they lent out, even to other banks. Those concerns were validated when Lehman Brothers declared bankruptcy and other big banks, such as Citigroup, Bank of America, Royal Bank of Scotland and Lloyds, required government bailouts to remain solvent.
Currerncy traders watch Libor rates constantly and make bets when they feel the spread between Libor and other types of rates represents an opportunity. But Libor affects a lot of ordinary people who have never even heard of it. The interest rate on many loans, including some student and business loans and adjustable-rate mortgages, are pegged to Libor, the same way other loans are pegged to the U.S. prime rate. So if Libor rises, the interest rate paid on a lot of typical loans will rise, too.
Since Libor also represents the level of concern bankers feel about getting their money back, it also reflects the availability of credit. And sure enough, when Libor spiked in the fall of 2008, it signaled the start of a credit freeze that left many business owners and consumers unable to get loans. Some banks even called in lines of credit, a move that pushed some smaller businesses into bankruptcy. So Libor can be a very accurate indicator of tough times ahead.
One oddity of the Barclays scandal is that traders allegedly forced Libor down, not up, which means that anybody getting a loan pegged to Libor may have unwittingly benefited from the machinations of bankers. There's also some evidence that regulators at the Financial Services Authority, and maybe even the Bank of England, knew that traders were reporting lower Libor rates than they were actually paying or receiving in the market, which means that the reported rates followed by everybody else would have been understated. So more investigating needs to be done.
Whatever the case, it's alarming that bankers were able to deliberately influence Libor at all. Borrowers need to know that the interest rates they pay are determined by ordinary market forces, not by the whims of pinstriped sharpies.
Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.