The LIBOR Scandal - Assignment Example

THE LIBOR SCANDAL by The modern financial world is a complex and integrated network that involves an interplayof numerous financial institutions, products and persons all linked together by information technology systems that make it possible for the day to day financial operations. Banks constitute the biggest and most important players in the financial world. Their every day dealings tremendously affect life, from an individual to a business or commercial standpoint. The impacts are both direct and indirect and are usually experienced everywhere. A major dealing of banks, which affects life, is the setting up of the London Interbank Offered Rate, commonly referred to as LIBOR (Bachert, 2007:32). Its use affects the pricing of loans, mortgages and other financial products thus directly affecting the people’s lives. This paper will therefore attempt to examine the process and the purpose as well, of how commercial banks set and determine the LIBOR rates. It will further explore the role of LIBOR in the commercial sector, and finally consider the impact of this rate on businesses and consumers. It is paramount to understand the meaning of the word LIBOR. In definition, LIBOR refers to the London Interbank Offered Rate. It is also referred to as ICE LIBOR. It can also be understood as a rate used by contributor banks in the event that one bank wants to borrow funds or inter-bank deposits, from another fellow member bank. Contributor banks refer to banks, which are involved in the setting and fixing of LIBORS. They include the Deutsche bank, Bank of America, Royal Bank of Canada, and the Royal Bank of Scotland. The LIBOR is thus a benchmark rate that some commercial banks in the world use to determine the rate at which they will lend short-term deposits to each other. It can be equated to the federal funds rate (Gumbo, 2011:23). The LIBOR, whose administration is under the ICE Benchmark Administration, is usually based on the five major currencies of the world. These are the United States dollar, the Euro, the sterling pound, the Japanese Yen, and the Swiss Franc. In order to understand well the process and why banks set their LIBOR rates, it is crucial that we briefly look at the circumstances that led to the formation of this rate. The history of LIBOR is traced back to the year 1984 although its first application in the financial and money markets was not until the year 1986 (Twomey, 2011:52). In the 1984, there was an increased growth in business using financial market instruments. More and more banks were increasingly using instruments such as foreign currency and forward rate arrangements in active trading. However, it was noted with concern that in future, business growth may be hampered unless there existed a standard and uniform measure to regulate the use of these financial instruments (Hou, 2014:34). The LIBOR was thus formulated. The process that banks use to set their LIBORS involves the derivation of an index that is used to measure and determine the cost that one bank will use to advance funds to another. This derivation process is reached upon by the contributor banks, which number about 18. The contributor banks represent the five major world currencies mentioned earlier on and give rates for seven different maturities. Therefore, 35 rates are given every day. The number 35 is arrived at by multiplying the 5 major currencies by the 7 maturities (Bachert, 2007:24). Maturities can be defined as length or duration of time given to repay or offset a debt. The process of determining LIBOR rates is a complex one. This is because it also involves calculations, which involve important variables such as the currency rates of the major world currencies, maturity, and most importantly time (Stamm, 2012:12). From June 2012, LIBOR came under public scrutiny because of controversy on individual panel bank submissions during the financial crisis. Allegations came up that certain banks had engaged in purposeful underreporting of their borrowed costs by large amounts to project financial strength in the then market uncertainty. These banks had manipulated their rate to get more gains based on LIBOR contracts. Many banks were named in this scandal, but those that reached settlements include Barclays, UBS, RBS and Rabobank. The investigation that was conducted in this matter revealed that the said banks had violated the false reporting provision of the Commodity Exchange Act. Banks that were found to have engaged in the LIBOR scandal experienced losses. For example, Barclays Bank paid a settlement of $453.6 million to British and U.S. financial authorities and also some of its senior executives including the then CEO Robert Diamond. A further controversy to the LIBOR scandal came when it was known that the Federal Reverse Bank of New York knew of manipulative activities in 2007 but never took a regulatory responsibility until the issue grew to be a scandal. The statistical evidence of the manipulative actions by banks that led to the scandal proved difficult to tell, internal communications that were recovered in the probe showed purposeful intent in misreporting. The main problem in dealing with manipulation regards the issue of the methods used to detect manipulation. The LIBOR scandal interfered with its commercial purpose because it made the process questionable. The role of the LIBOR in the world is immense, actually very significant. Its significance is felt by any individual or business that deals with a financial product. This includes campus students, who have student study loans, individuals with prepaid and credit cards, businesses servicing business loans or other instruments such as local purchase orders. In the commercial sector, the role of the LIBOR is majorly to set prices for financial products such loans and other debt instruments, interest rate swaps, the US dollar, and contracts such as the futures contracts. This is the primary role of the LIBOR commercially. For instance, Adjustable Rate Mortgages usually abbreviated as ARMs, is priced with reference to the 6-month LIBOR rate then an additional 3 percent is added to the pricing (Slee, 2011:25). ARMs are usually a popular choice for both prospective and existing homeowners as their rates are adjustable. In periods of stable or low interest rates, ARMs become very attractive. The other role of the LIBOR scandal made it difficult for it to serve as a sign that is indicative of the world’s economic environment. This is usually referred to as the additional significance of the LIBOR. For example, when the availability of credit is limited, it means that the appetite of foreign banks for the US dollar is very high. The US dollar LIBOR is cited most because the dollar is the world’s dominant currency (Twomey, 2011:42). High demands for the dollar usually increases the LIBOR rates for dollars, further tightening liquidity. A situation of tightened liquidity consequently means that commercial banks have very limited funds to advance to customers. This is a sign that is indicative of an imminent economic downturn (Slee, 2011:20). The LIBOR, as in the example, is therefore used as a sign of the future economic status. Therefore, the scandal that showed banks could manipulate their rates makes the process questionable and untrustworthy. The impacts of the LIBOR are far reaching. Its application in the setting and determination of prices of financial products affects basically anyone who has a financial product. As earlier mentioned, its effects are felt from a student who has a study loan to a homeowner and businesses that have business loans. Corporate institutions and governments also heavily deal with instruments such as bonds, futures contracts, and interest rate swaps whose prices are set from the LIBOR (Hou, 2014:56). Therefore, these institutions are also greatly impacted by the LIBOR. The LIBOR affects individuals and institutions in both a positive and negative manner. For instance, when the market interest rates are low, homeowners servicing mortgages especially the adjustable rate mortgage, which are tied to the 6-month LIBOR, experience a relief. On the other hand, a rise in interest rate creates a burden in the monthly interest repayments. During the global financial meltdown of 2008, which majorly affected subprime mortgages, homeowners were adversely affected. This is because almost every subprime mortgage had been linked to the US dollar LIBOR. The LIBOR may also affect the cost of borrowing. In developed countries, for example, LIBOR rates are usually indicative of uncertainties of the economy. In such times, credit is tight and banks continuously find it difficult to borrow from each other. Therefore, the availability of funds to advance to individuals and businesses is greatly limited and what is available is loaned at high interest rates. The LIBOR scandal showed that the LIBOR might fail to live up to the expectations set for it. In conclusion, the LIBOR, or the London Interbank Offered Rate, is a measure used as a benchmark to price financial instruments such as futures contracts and interest rate swaps. This is its main role. However, it has its other roles such as a sign of future economic conditions. The impact of the LIBOR on business and consumers is very significant (Stamm, 2012). This is because it is used to price products that are used by the individuals and businesses. Increases in the LIBOR rates consequently increases the prices of financial products thus putting pressure on the end consumer. The opposite is true with lower rates. The LIBOR is thus a very important component in the global financial markets. The LIBOR scandal painted the LIBOR badly showing that a few loopholes can be taken advantage of making it ineffective in its mandate. Reference List Bachert, P 2007, The LIBOR Market Model in Practice. New York. John Wiley & Sons. Gumbo, V 2011, The Libor Market Model and Its Application in the Safex-Jibar Market. California: Lambert Academic Publishing. Hou, D 2014, LIBOR: Origins, Economics, Crisis, Scandal, and Reform. New York: Federal Reserve Bank of New York. Slee, R 2011, Private Capital Markets: Valuation, Capitalization, and Transfer of Private Business Interests + Website. New York: John Wiley & Sons. Stamm, R 2012, Discounting, Libor, CVA and Funding: Interest Rate and Credit Pricing. London: Palgrave Macmillan. Twomey, B 2011, Inside the Currency Market: Mechanics, Valuation and Strategies. New York: John Wiley & Sons. Read More