A three minute explanation on the LIBOR fixing scandal

Libor Fixing Scandall

Any readers of this article will no doubt already be aware that Barclays Bank has recently come under a fire in the press for fixing LIBOR. Whilst focussing on bank-bashing, the facts are often overlooked, or at the very least poorly explained. This article explains what LIBOR is, how it was fixed and what the impact was.

What is LIBOR?

LIBOR, (pronounced – “Lie-bore”) is the London Interbank Offered Rate, and is best described as the interest rate at which the most credit worthy banks in London lend money to one another. The rate is calculated daily and is based on data submitted by the top 16 international banks operating in London. As well as forming the basis for inter-bank lending, the implementation of LIBOR spreads far and wide and includes; the underpinning of large volumes of business and personal loans and forms the basis for many derivative transactions (derivatives are complex financial instruments).

How was it fixed?

In order to calculate the daily average, the top 16 (eligible) financial institutions make submissions to Reuters who subsequently calculate and publicise the average. To prevent red herrings at either end, the highest and lowest 25% of submissions are eliminated.

On face value, the 25% elimination range should mean that the influence of any single organisation is limited, however, this is not necessarily the case. For example, the submission of a rate outside the normal range would almost definitely be eliminated, but it would still define the elimination range. For example, if an organisation submits a very high rate, it will be eliminated along with three other rates. The highest rate in the acceptable band would have otherwise been eliminated but is subsequently included, increasing the overall average slightly.

When you consider the possibility of multiple organisations collaborating, the possibility for influence on LIBOR increases substantially.

What does it Mean?

The main purpose of fixing the rate is to allow derivatives traders to benefit. The negative side effect is that those with LIBOR linked loans may have been paying artificially high or low interest rates, however it is virtually impossible to know which way the rate has been skewed. Aside from these obvious issues, any financial services scandal lowers confidence in the industry as a whole, and is also likely to lead to increased regulation, penalising legitimate organisations.

Bank bashing has become increasingly popular and not many will shed a tear for a bank, however it is important to remember that financial services provides a substantial proportion of the UK’s tax revenue and is one of our main industries. There is no justification for denying that illegal and immoral practises should not be condoned and the culprits should be dealt with accordingly, however, tarring the entire industry with the same brush is counter-productive.

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