Libor Manipulation

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ASSIGNMENT ON LIBOR MANIPULATION

FOR

INTERNATIONAL FINANCIAL MANAGEMENT

SUBMITTED TO

M.V.S KAMESHWAR RAO

ASSOCIATE PROFESSOR

SUBMITTED BY

RAJASEKHAR

TISHYA RAKSHITA

GIRISH CHANDRA P

POOJA AGARWAL

SEETHA RAMA RAJU


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LIBORINTRODUCTION

The London interbank offered rate (LIBOR) is a primary benchmark for short term interest

rates globally and is used as the basis for settlement of interest rate contracts on many futures

and options exchanges. It is used in

Used in loan agreements throughout global markets Mortgage agreements Considered as a barometer to measure the health of financial money markets.

Although reference is often made to the LIBOR interest rate, there are actually 150 different

LIBOR interest rates. LIBOR is calculated for 15 different maturities and for 10 different

currencies. The official LIBOR interest rates (bbalibor) are announced once a day at around

11.45am London time by Thomas Reuters on behalf of the British Bankers association

(BBA).

American dollar - USD LIBOR

Australian dollar- AUD LIBOR

British pound sterling - GBP LIBOR

Canadian dollar- CAD LIBOR

Danish krone - DKK LIBOR

European euro - EUR LIBOR

Japanese yen - JPY LIBOR

New Zealand dollar - NZD LIBOR

Swedish krona - SEK LIBOR

Swiss franc - CHF LIBOR

Each day, the BBA surveys a panel of banks, asking the question, At what rate could you

borrow funds, were you to do so by asking for and then accepting inter-bank offers in a

reasonable market size just prior to 11 am?. The BBA throws out the highest and lowest

portion of the responses, and averages the remaining middle. The average is reported at 11:30

a.m.

LIBOR is actually a set of indexes. There are separate LIBOR rates reported for 15 different

maturities (length of time to repay a debt) for each of 10 currencies. The shortest maturity is


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overnight, the longest is one year. In the United States, many private contracts reference the

three month dollar LIBOR, which is the index resulting from asking the panel what rate they

would pay to borrow dollars for three months.

WHAT WENT WRONG AND HOW DID THEY MANIPULATE?

The BBAs rate-setting process has certain inherent subjectivities. It is a self-reporting

process as each submitting bank provides to the BBA an estimate of the interest rate at which

the bank believes it could borrow from other banks. It is an estimate rather than an actual

interbank borrowing cost; by its very nature, it is not a precise, market-based price. The

global credit crisis in 2007 and 2008 exemplified the limitation in deriving LIBOR based on

estimated borrowing rates. During the peak of the crisis in which there was considerable

dislocation in the credit markets, LIBOR-submitting banks short-term financing composition

shifted from interbank borrowings to government-issued financing. The decline in interbank

borrowing may have made it more difficult for banks to accurately assess their interbank

borrowing rates.

In addition, LIBOR is determined based on a trimmed mean approach. Trimmed mean

averaging reduces the effects of outliers and can provide a more robust estimation of the

average than an arithmetic mean of all data points. In most instances, a single misstatedLIBOR submission would have very little or no impact on the calculated trimmed mean. For

example, in instances where both the manipulated submission and correct submission were to

fall into the same top or bottom quartile, there would be no impact on the resulting LIBOR

calculation. Two unlikely circumstances would have to occur for a single misstated LIBOR

submission to have a material impact on the calculation of the trimmed mean

i) a substantial differential between the top and bottom quartiles; and

ii) a bank would have to submit a misstated rate that would cause the rate either to be

included in the trimmed mean calculation as stated or to fall in a different quartile than it

would have had it not been misstated.

An example is illustrated below to explain how a small variation in the submitted rate by a

bank can alter the overall LIBOR rate.


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As illustrated in Panel A of Exhibit 2, based on the rates submitted by the 18 banks, using the

trimmed mean approach, rates for Banks 1 through 4 (top 4) and Banks 15 through 18

(bottom 4) would be excluded and the resulting average would be 4.15%. In Panel B, we

assume that the correct rate for Bank 2 is 4.9%, but is submitted as 3.35%. Panel C

demonstrates how this incorrect submission affects the ultimate computed rate. With the

submission at 3.35%, Bank 2 becomes the second lowest among the 18 submitted rates, and

the rate of 3.6% submitted by Bank 15, which was correctly excluded under the Panel A

calculation, is now included and part of the averaging process. The rate of 4.6% submitted by

Bank 5, on the other hand, is now excluded from the averaging process. As a result, the

calculated LIBOR has dropped to 4.05% (10 basis points lower than what it should be).

WHEN DID THEY START MANIPULATION?

Starting in the fall of 2007, almost five years ago, the financial press started writing about

potential abuses, reflecting what their sources were telling them.Gillian Tett in the Financial

Timesappears to have been the first: On September 4 of that year she quoted a banker as

calling Libor a fiction. TheWall Street Journalin April 2008 also ran the first of several

articles about Libors reliability.

At the same time, suspicions started being aired in more official circles, including at meetings

of bond trading associations and even in government publications, using data from the

markets themselves. How so? Largely it has to do with the nature of Libor and Euribor

themselves.
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These rates are set by panels of banks who meet daily to disclose the average rate at which

they can obtain unsecured funding for a given period. The Libor fixings, for example, cover

10 currencies, and the periods range from overnight up to a year. The top and bottom 25% of

these submissions are eliminated, and the rate is calculated using the average of the 50% that

are left.

But, critically, the rates that the banks submit in these sessions are not the rates they are

actually paying to borrow money, but rather the rates that they estimate they would have to

pay. Until the 2007 crisis, the Libor and Euribor rates tracked quite accurately the rates that

were actually transacted, and which are noted by central banks. But suddenly, after Lehman,

there was a very significant divergence between the benchmark Libor and Euribor rates, and

the actual transaction rates.

Jean-Franois Borgy spotted that at once. Hes a French former swaps trader with a long

record in the markets, having worked for Credit Lyonnais, Banque Worms and Natixis. He

was so struck by the change that, in October 2007, he gave a presentation to the annual

meeting of the European Bond Commission.

In a series of charts, he showed how the Euribor three-month rate had, since the 1999

introduction of the euro as a currency, almost without exception had been mirrored by the

effective European overnight rate based on actual transactions. The spread or difference

between this Eonia (Euro OverNight Index Average) rate and the Euribor rate had

consistently been 6.3 basis points, or 0.063%. But with the crisis it suddenly jumped to 40

basis points, or 0.4%. For a trader, thats a huge and obvious change. As Borgy explained in

his 2007 presentation, the Eonia rate is drawn from the same 47 banks who are involved in

the Euribor fixing; the difference is that Eonia reflects real transactions by the banks, while

Euribor simply reflects what the banks say they will do.

IMPLICATIONS ON GLOBAL FINANCIAL MARKETS

Parties involved in LIBOR linked financial instruments are numerous banks, Investors,

hedgers, Pensions funds, borrowers globally, mortgage borrowers etc. In general, lower

LIBOR hurts banks as lenders, benefits the borrowers and hence its against banks interest to

keep LIBOR low. However during the crisis, LIBOR levels have become a signal to the


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market. At that time irrespective of the gains/losses on the lending, a number of submitting

banks had interest in submitting a lower rate and keeping the LIBOR low.

IMPACT OF SCANDAL

During the crisis period investors and lenders lost money for LIBOR being artificiallylow and borrower saved money

In pre-crisis period, its difficult to judge who gained and who lost since LIBORfixing could be higher or lower than fair levels. Calculating fair level itself s difficult.

If a bank underreported by 20 bps we have to see whether the banks submission wasincluded or excluded. If included then they would have had only 2 bps impact on

LIBOR. However when multiple banks gives data in such a way that it get included in

that LIBOR will be higher.

Gross vs. Net Impact

In many instances, an institution that experienced losses on certain transactions as a result of

an artificially low LIBOR could have also experienced gains on other transactions. For

example, many corporations and financial institutions that purchase floating-rate investments

also issue floating rate debt. The key question in these instances surrounds whether the

financial impact should be assessed on a gross or net basis. If the latter applies, an analysis of

the total LIBOR-indexed portfolio may need to be performed in order to estimate the net

economic impact of any alleged LIBOR manipulation and to return the plaintiffs to the

economic position they would have enjoyed but for the alleged manipulation.

Complexity of Securitized Cash Flows

Many special purpose vehicles (SPVs) that issue securitized debt (also described as

securitized products), such as collateralized debt obligations, have both liabilities andunderlying assets that pay coupons tied to LIBOR. In many cases, SPVs have also entered

into LIBOR based derivative contracts to match the asset and liability cash flow

characteristics and/or protect investors against the impact of large, adverse movements in

LIBOR. The universe of securitized products is vast and such vehicles often have complex

waterfall structures and unique triggers that affect cash flows to the various investor classes.

Estimating the true extent of losses associated with LIBOR manipulation would in many

cases require sophisticated financial modelling capabilities.


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Forward Interest Rate Curves

There are other potential second order effects which are difficult to quantify or estimate. For

example, many interest rate derivatives are valued based on projected future interest rates

(usually referred to as a forward curve). Artificially low spot LIBOR could have a spill overeffect and lead to a depressed forward curve. This could affect the mark-to-market value of

many over-the-counter derivative instruments and could have major implications for

collateral and margin requirements.

WHO BENEFITED, WHO LOST?

BENIFICARIES FROM LIBOR SCANDLE

About $10 trillion in loans, including some credit card rates, car loans, student loans,

adjustable rate mortgages and some $350 trillion in derivatives are tied to Libor.Barclays, out

of its self-interest, ignored the fundamental principle that LIBOR and Euribor are supposed to

reflect the costs of borrowing funds in certain markets. Barclays traders located in New

York, London and Tokyo asked Barclays submitters to submit particular rates to benefit their

derivatives trading positions, such as swaps or futures positions, which were priced on

LIBOR and Euribor. Barclays traders made such unlawful requests routinely from the mid-

2005 until the fall of 2007, and occasionally thereafter until 2009.

This great scandal has benefited every single borrower in the $500 trillion market. Banks

were softening their costs of funds. They set rates lower than they otherwise would have.

They were doing so, to appear stronger relative to market activity during the financial crisis.

The banks were systematically lying on the low side during the crisis, a lot of people were

paying less on mortgages and loans.In the swaps, the banks paid interest at a variable rate

based on Libor. With Libor suppressed, the suits claim, the banks paid millions of dollarsless

than they should have.

VICTIMS IN THE LIBOR SCANDAL

People holding mortgages and notes were earning less than they were supposed to earn.A lot

of cities and pension funds and transportation systems had money in LIBOR based. They


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made a lot less money because the LIBOR was manipulated. There were investors who

purchased futures that allowed them to speculate on the direction of interest rates. Due to

Libor's alleged suppression, they have claimed lawsuits astheir futures contracts paid them

less than they should have.

A number of litigants have filed civil suits against the banks, claiming that they lost profits on

Libor-based securities. The City of Baltimore is suing because it claims to have lost millions

of dollars in the manipulation. Charles Schwab which is one of the Fortune 500s investment

funds purchased debt securities from the banks in which the interest payments rose and fell

with Libor. With Libor's alleged suppression, they were deprived of the higher interest

payments it deserved.

Investor Ellen Gelboim claimed that she purchased corporate debt that paid variable interest

based on Libor. She suffered lower returns as the banks held the rate down.Plaintiffs like the

City of Baltimore and a public employee pension fund in Connecticut say they suffered after

purchasing common financial products called interest rate swaps from the banks.

MEASURES CONSIDERED TO SET RIGHT LIB0R

Regulators face scrutiny:

Did they knowingly avert their gaze? Were they asleep at the switch?

Eventually, the scandal is likely to result in reforming Libor or replacing it with benchmarks

based on readily observable financial transactions.The full scope of the scandal has yet to be

seen. At the very least, it further erodes the public's already shaky trust in bankers.

The following are some of the measured to be considered to set right LIBOR.

1. The Central bankers are moving toward a dramatic overhaul of the benchmark interestrate Libor, which includes scrapping LIBOR rate entirely amid a rate-rigging scandal

that has engulfed some of the worlds largest financial institutions.


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2. A co-ordinated global initiative, by the U.S. Federal Reserve, the Bank of England,the Bank of Canada, and a number of other central banks has started discussing

critical changes to Libor.

3. The steps which steps are needed to be considered are

Restoration of credibility to Libor or Benchmark rate should be retired and replaced with a more transparent

process.

4. What next with Libor and if not Libor, what else and how to manage that transition,because there has to be absolute confidence in this. If Libor cannot be fixed, if its

structurally flawed and cannot be fixed which is a possibility there may need to be

different types of approaches and we need to think that through.

5. Other benchmarks in the market as an alternative to Libor are overnight Index Swaps,Treasury markets, or the market for repurchase agreements could be used as a stand-in

for Libor to gauge where interest rates stand.

6. Addition to determining alternatives for Libor, consideration of what transitional stepsneed to be put in place if Libor is replaced with another system of setting interest

rates. Such an evaluation would also need to take into due account the associated, and

considerable, transition issues.

WHERE IS THE LOOP HOLE IN THE SYSTEM?

The problem is institutional and systemic are bad systems convince good people they are

doing well even when they are clearly doing the opposite. If Barclay's is truly a bad system,

then no training would have prevented any of this because the corruption would come from

the top down. We may or may not ever know. However, your institution has no desire to be

manipulative, corrupt, or fraudulent. As a result, you must train your employees as to the

stringent code of conduct and ethics that will be maintained in your institution


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The loop holes in the system are: The relationship between the financial services industry

and its regulators, as well as the broader economy, does not necessarily need to be an

adversarial one of direct conflict and competition. There was a time, as remarkable as it may

seem, when banks did what they were supposed to do provide access to credit, facilitate

transactions, and put private savings into productive use without plunging the global

financial system and economy into a devastating crisis. Today, instability has become the

norm and nine-figure losses barely seem to make the third page of the business section. In the

aftermath of the financial crisis, there was an opportunity to learn from past mistakes, hold

banks accountable, and realign the world of finance with the rest of the economy and the

public good. It seemed like the perfect break point for regulators and politicians, backed by

the justified fury of a swindled public. These ostensible defenders of the public interest

should have won the match and changed the nature of the game right then and there. But they

did not.

And yet if there is anything that banks are better at than generating outsized profits and pay

checks, it is generating more major scandals. The London Interbank Offered Rate underpins a

vast portion of the global financial system, and its manipulation directly distorts the complex

web of interest rates dependent on it. Moreover, the reputational disintegration of the

industrysgentlemens clubthat set Libor rates further erodes the financial systems mostprecious commodity: trust. In this recent Libor scandal, we have what may be another perfect

break point for regulators.

On the surface, it might appear that such leniency was designed to give individual institutions

a "narrow margin" of freedom so they would not be completely stymied in red tape.

Ironically, and not all too unpredictably, that narrow causeway has created an ocean wide

floodgate of controversy and betrayal because a few chose to abuse the loopholes in the

system.

Documents

Libor Manipulation