WHEN a trader asks a colleague to submit false information in order to boost his profits, the correct answer is not “done…for you big boy”. This response was one of a host of exchanges involving 14 Barclays traders that were revealed as part of a probe by Britain’s Financial Services Authority (FSA) and American agencies including the Commodities Futures Trading Commission (CFTC) and the Department of Justice (DoJ).

The probe relates to LIBOR, the London inter-bank offered rate. LIBOR is supposed to be a trusty financial yardstick, measuring the costs banks incur when they borrow from one another. Libor rates are calculated for ten different currencies and 15 borrowing periods ranging from overnight to one year and are published daily at 11:30 am (London time) by Thomson Reuters.

For LIBOR, a borrowing rate is set daily by a panel of banks for ten currencies and for 15 maturities. The most important of these, three-month dollar LIBOR, is supposed to indicate what a bank would pay to borrow dollars for three months from other banks at 11am on the day it is set. The dollar rate is fixed each day by taking estimates from a panel, currently comprising 18 banks, of what they think they would have to pay to borrow if they needed money. The top four and bottom four estimates are then discarded, and LIBOR is the average of those left. The submissions of all the participants are published, along with each day’s LIBOR fix.

In theory, LIBOR is supposed to be a pretty honest number because it is assumed, for a start, that banks play by the rules and give truthful estimates. The market is also sufficiently small that most banks are presumed to know what the others are doing. In reality, the system is rotten. First, it is based on banks’ estimates, rather than the actual prices at which banks have lent to or borrowed from one another. “There is no reporting of transactions, no one really knows what’s going on in the market,” says a former senior trader closely involved in setting LIBOR at a large bank. “You have this vast overhang of financial instruments that hang their own fixes off a rate that doesn’t actually exist.”

A second problem is that those involved in setting the rates have often had every incentive to i.e. since their banks stood to profit or lose money depending on the level at which LIBOR was set each day. Worse still, transparency in the mechanism of setting rates may well have exacerbated the tendency to lie, rather than suppressed it. Banks that were weak would not have wanted to signal that fact widely in markets by submitting honest estimates of the high price they would have to pay to borrow, if they could borrow at all.

Many financial institutions, mortgage lenders and credit card agencies set their own rates relative to it. At least $350 trillion in derivatives and other financial products are tied to the Libor. It is controlled by the British Bankers’ Association (BBA).The flaw in the system is that banks can estimate their own LIBOR rates. Although these estimates are supposed to be calculated by a team that is ring fenced from other parts of the bank, the probe shows that they were influenced.

The scandal arose when it was discovered that banks were falsely inflating or deflating their rates so as to profit from trades, or to give the impression that they were more creditworthy than they were. The banks are supposed to submit the actual interest rates they are paying, or would expect to pay, for borrowing from other banks. The Libor is supposed to be an overall assessment of the health of the financial system because if the banks being polled feel confident about the state of things, they report a low number and if the member banks feel a low degree of confidence in the financial system, they report a higher interest rate number.

On 27 June 2012, Barclays Bank was fined $200 million by the Commodity Futures Trading Commission, $160 million by the United States Department of Justice and £59.5 million by the Financial Services Authority for attempted manipulation of the Libor and Euribor rates. The United States Department of Justice and Barclays officially agreed that “the manipulation of the submissions affected the fixed rates on some occasions”. The e-mails—the FSA tracked 257 messages asking for LIBOR and its yen and euro equivalents to be altered—make painful reading. That the investigation involved the FBI is a reputational disaster in itself.

In the case of Barclays, two very different sorts of rate fiddling have emerged. The first sort, and the one that has raised the most ire, involved groups of derivatives traders at Barclays and several other unnamed banks trying to influence the final LIBOR fixing to increase profits (or reduce losses) on their derivative exposures. The sums involved might have been huge. Barclays was a leading trader of these sorts of derivatives, and even relatively small moves in the final value of LIBOR could have resulted in daily profits or losses worth millions of dollars. In 2007, for instance, the loss (or gain) that Barclays stood to make from normal moves in interest rates over any given day was £20m ($40m at the time).

Yet a second sort of LIBOR-rigging has also emerged in the Barclays settlement. Barclays and, apparently, many other banks submitted dishonestly low estimates of bank borrowing costs over at least two years, including during the depths of the financial crisis. In terms of the scale of manipulation, this appears to have been far more egregious—at least in terms of the numbers. Almost all the banks in the LIBOR panels were submitting rates that may have been 30-40 basis points too low on average. That could create the biggest liabilities for the banks involved.

     As the financial crisis began in the middle of 2007, credit markets for banks started to freeze up. Banks began to suffer losses on their holdings of toxic securities relating to American subprime mortgages. With unexploded bombs littering the banking system, banks were reluctant to lend to one another, leading to shortages of funding system-wide. This only intensified in late 2007 when Northern Rock, a British mortgage lender, experienced a bank run that started in the money markets. It soon had to be taken over by the state. In these febrile market conditions, with almost no interbank lending taking place, there were little real data to use as a basis when submitting LIBOR. Barclays maintains that it tried to post honest assessments in its LIBOR submissions, but found that it was constantly above the submissions of rival banks, including some that were unmistakably weaker. At the time, questions were asked about the financial health of Barclays because its LIBOR submissions were higher. Back then, Barclays insiders said they were posting numbers that were honest while others were fiddling theirs, citing examples of banks that were trying to get funding in money markets at rates that were 30 basis points higher than those they were submitting for LIBOR.

Following the interest rate rigging scandal, Marcus Agius, chairman of Barclays, resigned from his position. One day later, Bob Diamond, the chief executive officer of Barclays, also resigned from his position.

Barclays later released documents that include a note-to-self written on October 29th 2008 by Bob Diamond immediately after a telephone conversation with Paul Tucker, a deputy governor of the Bank of England. According to the note, Mr. Tucker told Mr. Diamond he had received concerned calls from senior figures in Whitehall about Barclays. They asked why the borrowing costs the bank submitted each day to the panel setting LIBOR, a benchmark interest rate, were always amongst the highest. At the time, Barclays was thought to be having trouble raising cash in the inter-bank market, a potential sign of deeper troubles. Mr. Diamond’s told Mr. Tucker that Barclays had “a market-driven rate policy” (i.e. it based its interest-rate submissions on real transactions)—in contrast to other banks, which were posting rates that did not reflect their true borrowing costs. Mr. Diamond’s note ends thus:

Mr. Tucker stated the level of the calls he was receiving from Whitehall were “senior” and that while he was certain that we did not need advice, that it did not always need to be the case that we appeared as high we have recently.

The note was forwarded by e-mail on October 30th to John Varley, the bank’s chief executive at the time, and copied to Jerry del Missier, one of Mr. Diamond’s lieutenants at Barclays Capital, its investment banking arm. Mr. Tucker’s non-advice advice could quite easily be read as an order from the central bank (invoking “senior” government figures) to Barclays to submit lower LIBOR quotes so as to assuage concerns about its financial health. That apparently was the way Mr. del Missier read it, according to the Barclays documents released on July 3rd ahead of Mr. Diamond’s appearance before a parliamentary committee:

Bob Diamond did not believe he received an instruction from Paul Tucker or that he gave an instruction to Jerry del Missier. However Jerry del Missier concluded that an instruction had been passed down from the Bank of England not to keep LIBORs so high and he therefore passed down a direction to that effect to the submitters. Bob Diamond was subsequently questioned by the Parliament of the United Kingdom regarding the manipulation of Libor rates.

“IT’S difficult for Barclays…to be isolated on this,” said Bob Diamond, as he came to the end of three hours of mostly hostile questioning by a parliamentary committee on July 4th. Mr. Diamond was fighting to preserve not only his own reputation, but also that of the firm whose investment-banking arm, Barclays Capital, he had built from modest beginnings into one of the world’s biggest in little more than a decade.

Appearing before Parliament on 16 July, Jerry del Missier, a former senior Barclays executive and COO, said that he had received instructions from Robert Diamond to lower rates after Diamond’s discussions with bank regulators. He said that he had received information of a conversation between Diamond and Paul Tucker, deputy governor of the Bank of England, in which they had discussed the bank’s financial position at the height of the 2008 financial crisis. It was his understanding that senior British government officials had instructed the bank to alter the rates. Mr. del Missier’s testimony followed statements from Diamond in which he denied that he had told his deputies to report false Libor rates.

Tucker also but voluntarily appeared before parliament, to clarify the discussions he had with Bob Diamond. He said he had never encouraged manipulation of the Libor, and that other self-regulated mechanisms like the Libor should be reformed. “We thought this was a malfunctioning market not a dishonest market,” explained Paul Tucker, deputy governor of the Bank of England, towards the end of his much-awaited testimony to a parliamentary committee. Mr. Tucker was appearing at his own request to give his version of a telephone conversation in October 2008 with Bob Diamond. Asked whether he refuted the note’s suggestion, Mr. Tucker responded: “absolutely”. Did government ministers lean on him to give such an instruction? “Absolutely not,” he said, adding that the Whitehall figures with whom he had conversations during the crisis were senior civil servants, not government ministers. The denials undercut the claim by George Osborne, Chancellor of the Exchequer that ministers of the previous Labor government, including Ed Balls, now the shadow chancellor, were directly implicated in the LIBOR scandal.

Mr. Tucker said he had merely advised Mr. Diamond to be careful that Barclay’s money-market desk was not inadvertently sending up distress signals about the bank’s health by paying over the odds for short-term liquidity. The phone call took place in highly stressed circumstances, shortly after two other British banks had received capital injections from the government to prop them up. “Barclays was the next in line” of the dominoes that might topple, he said.

If Mr. Tucker did not bless the doctoring of LIBOR rates, should he have known it was going on? According to his memo, Mr. Diamond explained to Mr. Tucker that “not all banks were providing [LIBOR] quotes at the level that represented real transactions.” Mr. Tucker told the committee that he took this to mean that other banks, which had submitted LIBOR quotes, but did not need to raise cash, had under-estimated their likely borrowing costs. He did not interpret Mr. Diamond’s remarks as blowing the whistle on the misreporting of LIBOR, Mr. Tucker said—and that he wasn’t aware of any allegations that banks were deliberately “low-balling” LIBOR rates until very recently.

There was little in Mr. Tucker’s testimony to suggest that he did anything wrong or was negligent. But the link with the LIBOR crisis might still hurt his hopes of succeeding Sir Mervyn King as the Bank of England’s governor next year. Sir Mervyn has been criticised that he remained aloof from finance folk in the early weeks of the crisis and so was slow to respond. It would be harsh, then, if Mr. Tucker’s chances to get the top job are hurt by his efforts to keep in touch.

Two days later, it was announced that the U.K. Serious Fraud Office had also opened a criminal investigation into manipulation of interest rates. The investigation was not limited to Barclays. It has been reported since then that regulators in at least seven countries are investigating the rigging of the Libor and other interest rates. Around 20 major banks have been named in investigations and court cases.

The United States Congress began investigating on 10 July. Senate Banking Committee Chairman Tim Johnson said he questioned Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke about the scandal during scheduled hearings.

Documents released by the New York Federal Reserve Bank in July,2012 showed regulators in the United States and England had some knowledge that bankers were submitting misleading Libor bids during the 2008 financial crisis to make their financial institutions appear stronger than they were. Among other details, the Fed documents included the transcript of an April 2008 telephone call between a Barclays trader in New York and Fed official Fabiola Ravazzolo, in which the unidentified trader said: “So, we know that we’re not posting um, an honest Libor.”

Throughout the spring and summer of 2008, in the midst of increasing turmoil in the financial world, the Fed studied what was wrong with Libor. Two weeks after the April phone call, Geithner held a meeting called “Fixing LIBOR” with senior New York Fed staff members. A few weeks later, in a meeting with U.S. Treasury officials, New York Fed staffers, including Ravazzolo, presented slides saying there are “questions regarding Libor’s accuracy and relevance.”

In his second day of testimony to Congress, Geithner reiterated that when he was New York Fed president he told U.S. regulators about the rate manipulation and made recommendations to fix Libor to authorities in Britain where the interest rate is set. When asked by a Senate Banking Committee lawmaker if the New York Fed turned a blind eye to banks’ misrepresentations or if he was aware of any other regulator condoning bankers’ behavior, Geithner said “absolutely not.”

On June 1, 2008, Timothy F. Geithner – then president of the Federal Reserve Bank of New York – sent an e-mail to Mervyn A. King and Paul Tucker, then respectively governor and executive director of markets at the Bank of England. In his note, Mr. Geithner transmitted recommendations (dated May 27, 2008) from the New York Fed’s “Markets and Research and Statistics Groups” regarding “Recommendations for Enhancing the Credibility of Libor,” the London interbank offered rate.

The recommendations accurately summarized the problems with procedures surrounding the construction of Libor – the most important reference interest rate in the world – and proposed some sensible alternative approaches.

While the released memos suggest that the New York Fed helped to identify problems related to Libor and press the relevant authorities in the UK to reform, there is no documentation that shows any evidence that Geithner’s recommendations were acted upon or that the Fed tried to make sure that they were.

“At no stage did he [Geithner] or anyone else at the New York Fed raise any concerns with the Bank that they had seen any wrongdoing,” Bank of England governor Mervyn King said in testimony before a British parliamentary committee.

Later, this was what Ben Bernanke said in front of the Congress:

Senator Toomey:  The question is, why have we allowed it go on the old way when we knew it was  flawed for the last four years, with trillions of dollars of transactions?

Chairman Bernanke: Because the Federal Reserve has no ability to change it.

Mr. Bernanke emphasized that Libor-rigging is a major problem but was adamant that the Fed bore no responsibility for what happened, adding:

We have been in communication with the British Bankers’ Association. They made some changes, but not as much as we would like. It is, in fact, it is, you know, it’s not that market participants don’t understand how this thing is collected. It is a freely chosen rate. We’re uncomfortable with it.  We’ve talked to the Bank of England.

“SINCE we have not more power of knowing the future than any other men, we have made many mistakes (who has not during the past five years?), but our mistakes have been errors of judgment and not of principle.” So, reflected J.P. Morgan junior in 1933, in the middle of a financial crisis.

I just hope that is what the case is.

Some Facts:

On 29 May 2008, The Wall Street Journal (WSJ) released a controversial study suggesting that some banks might have understated borrowing costs they reported for the Libor during the 2008 credit crunch that may have misled others about the financial position of these banks. In response, the BBA claimed that the Libor continued to be reliable even in times of financial crisis. Other authorities contradicted The Wall Street Journal article saying there was no evidence of manipulation. In its March 2008 Quarterly Review, the Bank for International Settlements stated that “available data do not support the hypothesis that contributor banks manipulated their quotes to profit from positions based on fixings.” Further, in October 2008, the International Monetary Fund published its regular Global Financial Stability Review which also found that “Although the integrityof the U.S. dollar Libor-fixing process has been questioned by some market participants and the financial press, it appears that U.S. dollar Libor remains an accurate measure of a typical creditworthy bank’s marginal cost of unsecured U.S. dollar term funding.”

In the first quarter of 2009, Citigroup for example reported that it would make that quarter $936 million in net interest revenue if Libor interest rates would fall by .25 percent a quarter and $1,935 million if they were to fall by 1 percent instantaneously.

The Governor of the Bank of England, Mervyn King by the end of 2008, described the Libor to the UK Parliament saying:

It is in many ways the rate at which banks do not lend to each other … it is not a rate at which anyone is actually borrowing.

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