A lament for Libor

One Cent’s Worth
By MARC MEWSHAW  |  August 8, 2012

Ladies and gentlemen, London's burning. Not with the flames of the Olympic torch or the torments of a hellish heat wave. No, the firestorm that's got London's blood boiling was sparked by revelations that traders at the venerable Barclays bank have been futzing with a key financial benchmark named Libor. Their aim: gaming the $500 trillion derivatives market. But this isn't your garden variety fraud because the shenanigans actually benefited certain consumers.

If you've taken out a car loan, student loan, or adjustable-rate mortgage in the past 10 years, for instance, chances are the borrowing rate was pegged to Libor. If so, pat yourself on the back: the market manipulation saved you some bucks.

But before you start feeling too smug, consider that your gain came at the expense of one of society's most vulnerable demographics: retirees. (More on that later.)

Confused? Allow me to start from the top. The acronym Libor stands for London Interbank Offered Rate. It's the interest rate at which banks loan money to each other. The number is calculated every morning when 18 multinational banks submit the rate at which they expect to be able to borrow money from their competitors.

Except they didn't. While banks were supposed to report what they thought they could pay to borrow money, Barclays — and still-emerging evidence seems to implicate quite a few other banks as well — instead reported numbers that would help them win bets about the rate they helped control.

Mostly that fudging took the form of underreporting. Traders at Barclays courted fellow employees who submitted the bank's daily rate and induced them to turn in lowball numbers. Those phony reports helped traders come out ahead in bets involving esoteric derivatives called interest-rate swaps.

But wait — that doesn't make any sense, does it? Banks make their money by charging interest. Why would a bank shortchange itself by lowering its rate?

Part of the problem is that modern-day banks suffer from a schizoid partitioning that often places the interests of traders at odds with the good of the institution as a whole. Ever since laws banning commercial banks from operating as investment banks fell to vigorous industry lobbying in the late 1990s, banks such as Barclays have assumed dual roles. They both transact highly profitable trades and perform the socially desirable services of holding deposits and lending money. Those two arms of a bank are supposed to be hermetically sealed off from one another to prevent conflicts of interest.

What's come to light in the Libor scandals is the ease with which traders could sidestep those safeguards and rig the system to their advantage. That points to an industry-wide problem: buccaneering traders have hijacked the banks. Whereas once civic-minded, buttoned-down patriarchs drove the bus, now it's the profiteering frat boys' turn at the wheel. Their abuses have led to calls that the part of banks that trades stocks and the part that does useful things like take deposits be split once again into separate entities.

Back to those retirees. Why does the Libor rate-fixing hurt them? Many retirees depend for income (read: survival) on the interest generated by their bank deposits. If banks are artificially knocking down interest rates, that can spell disaster. For some, a dip of a single percentage point can make the difference between a comfortable existence and the bread line.

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