IEA releases The LIBOR Reader

At the end of June 2012, news of a further scandal in the banking industry broke – although, there was widespread knowledge about this problem within the industry. One UK bank, Barclays, had fines levied by the US and UK authorities for manipulating a key interest rate index called LIBOR. Other banks are still under investigation.

LIBOR is an important market interest rate indicator because it measures the rate of interest at which banks can lend to each other, although, as the article by Stephanie Flanders shows, it does not necessarily measure the rate of interest at which banks actually do lend to each other. Many other financial contracts are therefore priced using LIBOR. For example, it would be reasonable for a bank to offer a mortgage product with a floating rate of interest of “LIBOR plus 1.5%”. The bank could then be reasonably sure that, whatever happened to central bank interest rates, it could obtain funds at LIBOR to fund the mortgage, with a fixed margin for credit risk and expenses. In addition, many important derivative products are priced using the LIBOR interest rates. These products are used for long-term risk management purposes as well as being traded.

Quite quickly, two separate aspects of this scandal emerged. The first was that banks seemed to have been manipulating the rates that are used to calculate LIBOR so that their derivative positions on LIBOR contracts would show higher trading profits. The second was that, at the height of the financial crisis, Barclays bank seems to have reduced its LIBOR submissions to the British Bankers’ Association in order to give the impression to the market that others were willing to lend to Barclays at lower interest rates than was actually the case. The idea of this action was to give the impression to the market that those lending money to Barclays were less concerned about the credit risk of Barclays than they were in practice.

The excellent short articles in this reader on the LIBOR scandal look for a deeper understanding of the crisis rather than taking the view that: “something has gone wrong, therefore we obviously did not have the rules to stop it, therefore we need more rules.”

Contents:

LIBOR manipulation scandal is a disastrous own goal for City

Allister Heath, City AM (Editor&rsqu