Libor Scandal Could Rock the Financial World
London is shining in the spotlight as the host of the Olympics, a welcome distraction from the Libor (London Interbank Offered Rate) rate-fixing scandal that threatens to rock the financial world.
The Libor scandal is far reaching for both consumers and financial institutions. Consumers may have had their interest rates on mortgages, student loans and even credit cards affected by this controversy. In addition, regulators are investigating whether banks rigged interest rates to gain more profits or perhaps reported lower interest rates on loans in order to appear more financially stable.
The name London Interbank Offered Rate (Libor) is geographically misleading. It is simply the interest rate that banks around the world charge to lend to each other. It is computed in London but used as a global benchmark for interest rates, and, according to some analysts, has affected more than $360 trillion in financial products.
Libor reflects the borrowing costs of 18 banks, including firms in Europe and Japan as well as three American institutions: Bank of America, Citigroup and JPMorgan Chase. A daily survey in London calculates Libor by averaging the rates these banks think they would have to pay to borrow from other banks. The banks, not the market or the government, set the rate. Some credit card, mortgage, student loan, auto loan, and business loan interest rates, as well as some financial products such as derivatives, are based on Libor. A rigged Libor rate means that millions of people around the world might have unknowingly paid more or less interest than they should have.
The big losers in this scandal could be cities, mutual funds and pension plans that may have earned less than they should have. Cities such as Baltimore say the low interest rates underpaid the city on investments, added to budget deficits, and forced the closure of schools, fire stations and recreation centers. Baltimore has filed a class lawsuit against the banks, and more cities and states may join in.
Sixteen banks are under investigation for manipulating the Libor or other rate indexes to get extra profits and limit losses on their trading positions.
On June 27, 2012, London’s Barclay’s bank was the first bank to confess to misconduct. Between 2005 and 2009, the bank manipulated Libor submissions to give a healthier picture of the bank’s credit quality and its ability to raise funds. It reached an agreement with British and American regulators to pay a $450 million fine, and three top officials of the bank resigned. Adding to the outrage is the discovery that regulators in the UK and the U.S. may have known that Libor was being rigged as far back as the fall of 2007 but took limited action. Libor investigations could cost banks billions of dollars in penalties.
Libor is different from the prime rate. The prime rate, published by the Wall Street Journal, is the rate banks charge favored, or “prime”, consumers. It is tied to the Federal Reserve’s federal funds rate. It is a consensus rate from the ten largest U.S. banks, and it changes when seven of the ten banks change their rates. Most credit cards have a variable rate that is tied to the prime rate. Libor, on the other hand, is the dominant index for subprime loans, especially mortgages.