The LIBOR rigging scandal. What was it and why was it so significant?
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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.
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