Let's Send the Libor Rate-Riggers to Jail

Judgment day has finally come for all of the bankers who’ve been manipulating Libor bank-lending rates for their own personal gain over the course of the past few years. The United Kingdom’s Financial Services Authority recently released a full report on the Libor rate-rigging scandal, and it doesn’t pull any punches. Not only does it say that the existing system is broken and built on “flawed incentives, incompetence and the pursuit of narrow interests,” but it also declares in no uncertain terms that the bankers responsible for the scandal should go to the slammer. The FSA’s managing director Martin Wheatley wrote in the report that the Libor rate-riggers should “pay the price, and if that includes jail for the most extreme fraud in the system, then that’s what should happen.”

Let’s back up a second. Libor — the London Interbank Offered Rate — is used by bankers to calculate the cost of lending money from one bank to another. The interest rates are generally very low, and allows world banks to lend money amongst themselves — and thus keep world markets more liquid — with great rapidity. In effect, Libor allows banks to reduce their risk by as much as possible, especially on long-term financial products like mortgages and student loans, and it also forms the basis for consumer interests rates; if banks pay more for money because Libor went up, you likely will too.

In theory, it works great. The Libor would allow banks to make longterm loans, but the Libor refreshes itself on a daily basis, giving them the flexibility to adjust the rates according to banks’ own assessments of their risk and not the volatile movement of the market. The only problem is that because each bank estimates its own borrowing costs to calculate the average, there’s nothing stopping them from making their situation look a little more positive that it actually is. That’s exactly what banks have been doing for the past few years. In the throes of the financial crisis, September 2008, Willem Buiter, a member of the Bank of England’s Monetary Policy Committee, called Libor “the rate at which banks don’t lend to each other” and said that the “fundamentally flawed” system needed to be replaced.

Four years later, the U.S. Department of Justice formally launched an investigation into Libor rate-rigging and eventually hit Barclays with a $160 million fine having found that the bank was submitting false rates to make themselves look healthier than they actually were. Over time, you see, these little exaggerations add up and create false confidence in the market. That’s the kind of thing that turns the actions of a few number-fudging bankers into a full blown financial crisis. Eventually, Barclays paid out $450 million worth of fines for its role in the scandal.

To prevent people from rigging Libor rates in the future, British regulators have decided to completely overhaul the system. Within the next 12 months, a new regulatory body called the Financial Conduct Authority will be set up within the Bank of England to monitor Libor rates, and the system itself will be greatly simplified to increase transparency. Instead of calculating averages for ten different currencies, regulators will bring that down to five and cut the number of Libor rates from the current 150 to a more manageable 20. They’ll also delay banks’ rate submissions by three months in order to discourage false reporting. “Libor needs to get back to doing what it is supposed to do,” reads Wheatley’s report, “rather than what unscrupulous traders and individuals in banks wanted it to do.”

Not everybody thinks that Libor can be fixed, though. New York Times economics writer Floyd Norris calls Libor “a fiction … based on calculations that have little basis in reality.” He goes on to point out how the deception has continued but is hard to track because banks work hard to keep it under the radar. Gary Gensler, the chairman of the U.S. Commodity Futures Trading Commission and an Obama appointee tasked with investigating Libor, recently said, “History shows that something that is prone to abuse will be abused, and that even people of good faith can have a difficult time estimating when there are no observable transactions.”

So it would seem that it’s about time to make some examples out of some naughty bankers. Like Wheatley said, some of these guys are committing pretty serious fraud, fraud that’s costing consumers hundreds of millions of dollars. The overhaul introduced by the FSA may or may not work, and Libor itself might be fatally flawed. But inevitably, somebody ought to pay the price. Fines are fine, and all that. But banks can always make more money, whereas sending a few crooks to prison could have the lasting effect of discouraging other bankers from becoming crooks themselves. Because nobody likes crooks. Come to think of it, nobody really likes bankers either.