Business Columns

Libor scandal reveals holes in system

  • Dhirendra Kumar
  • |
  • Updated: Jul 16, 2012 11:52 IST

I’m a little surprised by the shocked outrage that has erupted in response to the Libor scandal.

At this point, if you have understood even a little from what has happened in the last 5 years, the correct response would be, “Well, obviously they were cheating on the Libor. What else did you expect from these financial types?”

For those who still aren’t familiar, here’s a very brief introduction.

The Libor (London Interbank Offered Rate) is an interest rate that is calculated from information provided by major banks in London. It’s the most widely-used benchmark for setting short-term interest rates around the world, with a reported 300-500 trillion dollars’ worth of instruments pegged to it.

However, it has transpired now that for at least the five years, the banks have been manipulating this rate, resulting in billions of dollars of undeserved gains and losses for various entities.

Libor was a scandal waiting to happen because of the way it was generated.

Here’s the official method, as stated on the British Bankers’ Association’s Libor website: “The rate at which an individual contributor panel bank could borrow funds, were it to do so by asking for and then accepting interbank offers in reasonable market size, just prior to 11.00am London time.”

It further explains that the rate “must be formed from that bank’s perception of its cost of unsecured funds”.

Strange, isn’t it? A world that still trusts perceptions to be reported honestly?

The basic problem is that the modus operandi for setting Libor belonged to an earlier era where the default was to trust people in finance. In today’s world, the appropriate default setting should be mistrust. Assume universal guilt until innocence is proven.

This has implications not just for things like Libor, but every little financial service that we evaluate and consume at the retail level.

 

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