The LIBOR rigging scandal. What was it and why was it so significant?
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So a while back an individual (I think it was a Saudi Prince, don’t quote me there) wanted to take out a HUUUUGGGEE loan, much bigger than any one bank was comfortable making. So several large banks got together in London and made a deal with each other to “co-write” the loan and created an interested rate to charge the Prince. It was a clean way of essentially making a super massive loan as simple as possible. The system the banks crafted became known as LIBOR – the London Inter-Bank Offered Rate and it became the unofficial way of determining interest rates in general in much of the world. So everything from Mortgages to Student Loans, personal debt, etc. started falling into the LIBOR system.
Now when you have every bank competing individually to make loans, you get competition on rates, which “helps” the consumer in the same that Best Buy and Target competing to sell you a TV helps you, it keeps rates low and fair.
The problem was the LIBOR was in it’s origin a group banks negotiating *with each other* what the peg everyone’s interest rate at, which is essentially collusion or price fixing. And it turns out that was eventually what started happening, the banks were agreeing behind closed doors to fix interest rates on their loans to benefit themselves and hurt consumers.
The result was basically England pulling the “control” of LIBOR away from the private banks and putting it in the hands of the government and eventually, they did away with the LIBOR system entirely (I believe this happened in 2021)
The LIBOR rigging scandal was a big deal because LIBOR is a big deal – the mechanics of rigging the rate are actually pretty simple.
LIBOR stands for the London Interbank Offered Rate, and it’s the average rate that Banks can use to borrow money from each other.
*Don’t banks already have a bunch of money? Like the money we keep in our accounts?*
Yes, they do, but sometimes they don’t have enough. Banks are required to keep a certain amount of cash available in case of bank runs, where a lot of people try to withdraw their cash at once. Sometimes the Bank won’t have enough cash – maybe they had more ATM withdrawals than expected one day, or someone didn’t repay their loan on time. To meet their cash requirement, banks will borrow from other banks who have the *opposite* problem: excess cash, because customers withdrew less money than expected, or someone prepaid a loan. The rate that these banks will lend to each other is called the *Interbank Rate*.
There are a few interbank rates – for example, the Federal Reserve sets a target rate (the federal funds rate) that Banks use when they lend to each other (I won’t get into the mechanics of how this rate is set here, but I’m happy to expand on it if you’d like).
LIBOR, as its name would imply, is also an interbank rate. This rate is set by reaching out to certain banks and asking, “If you had to borrow money from another bank by 11:00 a.m. today, what rate would they charge you?”.
You can see how this would be easy to manipulate. All it takes is a few of those banks lying about the rates they could receive, and they can skew the number up (or down) as needed.
*But why do we care what banks charge each other in interest?*
Because it usually impacts what *we* get charged in interest. Imagine you have a floating rate loan set at LIBOR + 2.00%, and LIBOR is currently 3.00%. You’re paying 5.00% interest on your loan.
This money usually isn’t coming out of the Bank’s reserves – they’ll go out to the money market and borrow the money for your loan from another bank on a short term basis. *In theory*, the bank should borrow the money for your loan at LIBOR (3.00%), lend it to you at LIBOR + 2.00%, and pocket the extra 2%. What happens, though, if the bank only *says* their interbank rate is 3.00%? What if the banks agree to *say* that LIBOR is 3.00%, but lend each other money at 2.00%? Well that’s an extra 1.00% in profit for the bank, all because they lied about how much it costs to borrow money.
The scandal was significant because LIBOR was an incredibly important interest rate. It was used to determine mortgage rates, loan rates, bond rates, derivative rates; it impacted everything from credit card rates to student loans to commercial lending to mutual fund returns. Now, you’re seeing a lot of places move away from LIBOR-based pricing as a result of the scandal, and the rate will be fully retired by June 2023.
Any loan which charges interest has a few different factors which contribute to that interest rate: cover running costs, profit, and **risk**.
You might be used to the idea that a bank will calculate whether you *personally* are a high or low risk for a loan. Good credit history => low risk.
But what about applying for a loan during a booming economy compared to applying for the same loan during a global recession? Now we have a background level of risk which is nothing to do with you personally. That background risk changes constantly, and every lender needs to factor it into their rates for any kind of loan.
So how would you get a handle on what that risk is, so you could set the rates for your loans? To answer that you need to strip away all the risk attached to the individual borrower so you’re left with only the background risk. You’d ask the question “*If I had the most trustworthy borrower in the world, borrowing money in the market today, what interest rate would I charge them?*”
And where would you find the most trustworthy borrower in the world? Well, a group of banks in London made a pact. They were already borrowing and lending amongst themselves because banks are most profitable when they stay exactly in their sweet spot for money held vs money lent. And like any loan, they charge each other interest. And they basically said “The most trustworthy borrower in the world is one of my fellow London banks, so the interest rate that I charge them is about as pure a measurement of background risk as I will find”.
So once you know what the London Inter-Bank Offer Rate is, you van add on your running costs, profit margin and individual risk calculation and figure out how much interest to charge your customer.
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