FINANCIAL SCENE The Libor scam is centred on an age-old practice followed by top London banks

The banking industry in the West with its reputation already tarnished by several high profile scandals could easily do without the latest one, which is centred on and, hence, called the Libor scam.

Like other previous financial sector scams — the sub-prime mortgage crisis in the U.S. (2008), and the more recent rogue trading at JPMorgan Chase, the Libor scandal seemed confined to one institution or activity initially, only to acquire menacing proportions very quickly.

Far from being restricted to one party or practice, these scams have a knack of drawing in a number of other players, and encompassing other related activities. Globalisation ensures that no such problem can remain confined to within the geographical boundaries of any one country.

For instance, it is well known that the sub-prime mortgage crisis in the U.S. spawned the much, bigger global financial and economic crisis. Banks in the U.S., which initially flouted all credit assessment norms and lent to home buyers with no standing whatsoever, were later complicit in designing and selling complex financial instruments to package and sell those risks (along with better quality ones). With so much of financial engineering going into these products, it is alleged that in many cases even those who designed or sold them did not understand their full implications. The globally renowned rating agencies did not fare much better: they gave routinely high ratings to a number of these products .So much so, in many cases, the investors were not put on guard.

The latest scam is in an entirely different category. It is centred on an age-old practice followed by top banks in London to arrive at benchmark rates (Libor), which are then used for a large number of commercial transactions. Libor is the London inter-bank offered rate, a benchmark for many other rates, from commercial loans to mortgages. More recently, Libor has been used as an index for derivatives, which are complex instruments whose value is derived from a benchmark. Libor is the most widely used interest rate in the world. There are other reference interest rates to be sure — SIBOR (for Singapore) and MIBOR (for Mumbai). A major reason, of course, is London’s pre-eminence among financial centres, which is unlikely to be challenged even by the rise of centres such as Singapore.

To understand the real significance of the scam, one has to look at the procedure followed for arriving at the Libor. Leading banks in London are called upon, once every week day, usually at 11 a.m. London time, to tell Thomson Reuters the interest rate they would pay on a loan from another bank. The rates are averaged. (Thomson-Reuters drops those rates in the highest and lowest 25 per cent, and average the 50 per cent in the middle). There are as many as 150 Libor rates in dollars and other major currencies varying in periods from overnight to one year. The whole procedure is overseen by the British Bankers’ Association. The fraud has occurred because there is a fine distinction between what banks would pay and what they actually pay (on loans taken from another bank).This is significant, and is at the heart of the scandal.

Some banks artificially inflated or deflated their rates to suit their own position. Since that impacts the Libor that is eventually quoted as the reference rate, it is easy to see how some customers benefit while others lose.

If the Libor was rigged artificially high, customer who has taken a loan ends up paying more than what he should have. If the Libor was fixed artificially low, the customer pays less.

A major development that has probably aided the banks in quoting rates that deviate from reality is that after the crisis there are few inter-bank transactions on which to base the Libor. Many banks have been content to park their funds with central banks, rather than lending to other institutions.

Naturally, those who feel they been ripped off have gone to the courts. Law suits have been filed against banks which had participated in the Libor setting process. In the most sensational development of its kind so far, the British Bank Barclays agreed to settle charges of manipulation and pay British and American regulators $450 million. Its senior executives have resigned or asked to go. Other banks are facing probes and regulatory scrutiny. It is highly unlikely that the last word will be said soon on a scam which is growing in intensity by the day. Although there is no direct connection, the Libor scam affects India, too. Corporates who have borrowed abroad would have had their loans benchmarked against rigged Libors. A scrutiny by the RBI might unearth some cases. But obviously the biggest blow is in terms of loss of trust, which banks need to, and have assiduously cultivated over the years.

The process of regaining the trust is going to be extremely painful for many of the world’s leading banks, which have been embroiled in one crisis or other recently.