Here’s what the LIBOR scandal is all about. The London Interbank Overnight Rate is, theoretically, just that — the interest rate that London’s major banks charge each other for overnight loans. Because this is theoretically a common, relatively risk-free transaction, this interest rate provides a good metric for overall market sentiment. I.e., if Barclay’s is willing to lend to HSBC at an annualized interest rate of 2.0% for a simple, overnight loan, that’s a good indication that they weren’t able to find many relatively risk-free opportunities for an interest rate much higher than that. If Barclay’s demands an interest rate of 3.5% for that transaction, even though it’s risk-free, that’s a good indication that the market is driving yields in general higher.
So the LIBOR is used as a proxy for the “risk-free” rate of financial theory, like Treasuries are in the U.S. And so lots of other interest rates, on riskier assets (such as your mortgage) are set as “LIBOR + X.”
Which explains both (1) why banks in London tried to ‘fix’ Libor and (2) why this is a problem. In brief: Because so many other interest rates are set as “LIBOR + X,” the values of many, many other financial assets (estimated in the trillions of dollars) move with the LIBOR. Suppose that mortgages are being offered for “LIBOR + 2.5%.” Suppose also that LIBOR was very low when one portfolio of those mortgages was issued. Now, if LIBOR goes up, then interest rates on new issues of mortgages will be higher; this will mean that the value of the old portfolio of mortgages will go down, because you (an investor in mortgage portfolios) could now get a higher return for the same risk. To generalize this insight: an increase in interest rates decreases the value of portfolios of fixed-income assets that were issued at earlier, lower interest rates. So, if you are in any position to “short” the old portfolio of mortgages (or fixed-income portfolios more generally), you stand to benefit from an increase in LIBOR. But, of course, if you’re just an ordinary middle-class person who wants to get a mortgage at a decent rate, you stand to be hurt by this. (In truth, most of the LIBOR manipulation wasn’t done to change the value of mortgage portfolios, but that of complex derivatives contracts — the same basic ideas apply, they would just be harder to express in a quick blogpost.)
So clearly, LIBOR manipulation can pit the interests of bankers and traders against those of society as a whole. Which is both why it’s a serious problem, and something that bankers and traders had a predictable incentive to do.
The thing that’s puzzled me, as I’ve read about the LIBOR scandal, was that this was very predictable and was made incredibly, unbelievably easy for bankers and traders to pull off. The question you may have been wondering about, as I described LIBOR above was, “How do they measure this?” And the answer is: “Very naively.” The official LIBOR figure is issued by a private association, and is based off of simply surveying banks, asking them, essentially, “At what rate could you get an overnight, uncollateralized loan today?” I.e., it’s based off of self-report, which is really easy to manipulate, obviously.
And manipulate they did. Traders who stood to benefit from a higher (lower) official LIBOR rate emailed people both within their own banks and others requesting that that they report higher (lower) numbers. There was also a second category of LIBOR fixing that’s getting talked about: During the financial crisis, banks apparently colluded — possibly with their own regulators — to issue low numbers. The reasons for this are perhaps more understandable. Having a high “overnight rate” is a sign of distress, and lack of market confidence, in your bank. So banks issued lower numbers during the crisis (again, with some evidence that London regulators knowingly went along), to prevent a downward spiral of disappearing confidence begetting disappearing access to financing begetting more disappearing confidence, etc.
So how do we fix this, and stop this fixing? Well, the problems with LIBOR entirely lie in the problems with inaccurate, manipulated reporting. The basic, theoretical function of the LIBOR number — to serve as a proxy for the “risk-free rate,” to which other assets can be tied — is necessary and good. So we just need to fix the reporting. Here are three pretty obvious, pretty easy solutions: First, rely on actual measured market rates, instead of banks’ self-reports. In other words, rather than just asking banks what rate they could get for an overnight loans, actually look at the overnight loans on their books, and audit the reported rate. Second, if the market is really thin, such that the banks don’t really have overnight loans recorded on their books, meaning that we have no other option than to rely on hypothetical reports, then ask banks two questions instead of one: Ask both, “At what rate could you get a loan?” and “At what rate would you lend to others?” and cross-check them. Third, maybe have an official, publicly accountable regulatory body report LIBOR, rather than a private association that is arguably so close to financial elites that it purposefully overlooked their collusion.