What Is Libor and How Is It Calculated? How Has Libor Been Used Historically?

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While still working on improving LIBOR, the Fed through Bernanke made some recommendations such as: (a) to create a new rate to replace LIBOR that is based on the cost of collateralized borrowing between banks, or (b) to create a rate similar to Overnight Index Swap (OIS) rate, which is sort of a measure of global central bank borrowing rates. However, he also pointed out that it would be extremely difficult to dissuade the global economy from using LIBOR as it’s already too widely adopted.

6. What legal problems have been identified? What non-legal ethical problems have been identified?

There are some legal problems that have been successfully identified: (a) Barclays’ role and admission in LIBOR fixing and (b) the high possibility that other banks were also involved besides Barclays (such as UBS, which will be discussed in the following paragraph). Barclays admitted that it attempted to manipulate LIBOR in two different periods i.e. Jan 2005 - July 2008 and mid-2008 to May 2009. Of particular interest is the first period as the manipulation happened when the economy was still growing steadily and was attributable solely to the banks’ greed[2]. The banks’ motive for manipulating LIBOR in the second period may be deemed slightly more acceptable due to the economic instability and the pressure from Bank of England not to submit high rates, which could cause panic as to the banks’ solvency at a time of crisis.

(c) The legal crime committed by UBS involved UBS attempting to manipulate LIBOR benchmark and other rates by gaming its own rate submissions, as well as by means of conversations and requests made to and through inter-dealer brokers and other LIBOR panel banks. More than 2,000 instances of unlawful conduct involving dozens of UBS employees, colluding with other panel banks and inducing inter-leader brokers to spread false information and influence other banks were released to the press[3].

From the non-legal ethical perspective, the illegal behavior by the senior people in these banks is depressing, as pointed out by a Wharton finance professor, Franklin Allen[4]. Another professor at Bradford University School of Management, Dr. Abhijit Sharma, argues that regulation alone is unlikely to change this behavior. We need to consider ethical issues such as weak leadership, poor management of risks, inadequate training, and limited understanding of the consequences of such malpractice. He also argues that ethics should be integrated deeper into academics which so far has been traditionally covered only in passing[5].

7. Who has been negatively impacted by LIBOR and what measures are they taking? Who has been positively impacted? Is it fair?

* Note: negatively impacted; positively impacted.

There are numerous parties who have been hurt by LIBOR rate manipulation. Banks involved in lowering the LIBOR rate now face allegations by dozens of insurers, investors, and lenders and this would involve tens of billions of dollars in claims. Fund managers like Charles Schwab Corp say that they were cheated out of returns on bonds with artificially low rates as well as cities and hedge funds with financial contracts squeezed by traders who allegedly colluded with each other.

Those who were hurt by this manipulation have been filing lawsuits against these perpetrators. However, it wouldn’t be easy for the plaintiffs (those who brought the lawsuits up) to win in the court. The plaintiffs must prove that banks successfully manipulated LIBOR and caused the plaintiffs to suffer a loss.

Some investors and analysts are forecasting huge damages as a result of this LIBOR manipulation and in one report by Macquarie Research, it estimated that the involved banks would face potential legal liability of about $176 billion, based on the assumption that LIBOR was understated by 0.4% in 2008 and 2009. These lawsuits will take many years to get resolved. Several banks that face biggest potential payouts include Deutsche Bank AG, Royal Bank of Scotland PLC, Barclays, Bank of America, and J.P. Morgan.

A lot more financial institutions would be badly affected, because LIBOR affects commercial paper, corporate bonds, syndicated loans, derivatives, adjustable-rate mortgages, and student loans. So, the aftermaths are pervasive and wide.

For loans pegged to LIBOR, this benefited borrowers by lowering their payments. Lenders and investors were among those hurt due to the lower LIBOR.

Holders of interest-paying bonds probably would be the ones who would get their money back the easiest. However, they must be able to convince the jury that LIBOR was too low to show that they were paid too low interest.

Money managers such as BlackRock Inc., Vanguard Group Inc., and Federated Investors Inc. have said they are investigating whether their funds were harmed as well. Other large investors like California Public Employees’ Retirement System are also looking into the possible loss due to this manipulation, as well as the largest public pension fund in the US.

It is obviously not fair for many parties. Dishonesty would never see fairness in it. The number of parties hurt and the wide-spread negative effect felt by many individuals, companies, and cities could never be justified.

8. What alternatives for LIBOR are in use? What alternatives are proposed to replace LIBOR? What characteristics are required? What are the advantages and disadvantages of each?

What alternatives for LIBOR are already in use?

There have been a few alternatives which were either in use temporarily, or are being discussed as possible replacements to LIBOR. Before LIBOR manipulation was eventually uncovered, the Journal calculated (a) an alternate borrowing rate for each bank using information from the default-insurance market. The use of this alternate borrowing rate was backed by academicians such as Mikhail Chernov, a finance professor at London Business School and David Juran, a statistics professor at Columbia University.

* Note: disadvantages; advantages.

What alternatives are proposed to replace LIBOR?

Robert Fuller, the head of New Jersey’s Capital Markets Management LLC, is considering to use (b) the federal-funds rate (the rate at which banks loan to each other overnight) in swaps contracts. The downside of this is that it is subject to changes in the Federal Reserve’s monetary policy. There is uncertainty about how the market will react when the Fed eventually unwinds all the monetary