Barclays and the Libor Affair

01 August 2012 Robert W Vivian, University of the Witwatersrand

Bob Diamond, chief executive of Barclays plc, resigned his position on 3 July 2012. It is alleged that Barclays, in collusion with other major banks and perhaps sanctioned by the Bank of England, manipulated the London Inter-bank Offered Rate (Libor) by making false submissions.

Barclays plc has been in the news of late over the Libor affair. Libor stands for the London Inter-bank Offered Rate and is typically described as the "price” or "rate” at which banks lend money to each other. Contrary to public opinion Libor is not a price or rate!

A rate is the price at which money is lent. If you go to the bank and borrow money (at say 15%) that is the price at which you lease capital from the bank. How this price or any price is arrived at is a matter of considerable interest. For centuries economists have been working on a convincing theory of price, without success.

Marx missed the mark

Marx, for example, suggested the Labour Theory of Value, a theory quickly dismissed as not even close to the truth. Earlier this year I argued, at a conference, for the economic theory of information as the basis of price. This argument leads in to the efficient market hypothesis, discussed in detail by my colleague Christo Auret and myself in FA News, April 2012.

In arriving at a price, a brilliant Dutch lawyer Hugo de Groot argued the process involves an offer and an acceptance. A price then becomes the consensus between bidding and asking "prices” at which the transaction is actually conducted. But we must steer clear of confusing bids and offers with "price”.

These "prices” are not prices at all. If you have a car which you are very fond off, you may ask say R150 000 for it. The second hand car dealer may tell you it is a piece of junk and bid (or offer) R5 000 only. In the end you both agree on R25 000 as the price for the car. The price is R25 000. It is neither R5 000 nor R150 000, despite these values being referred to as the bid / ask prices. The price is the value at which the transaction is actually carried out.

Defending Barclays

How do we defend Barclays plc in the rate manipulation saga? The first thing to realize is that Libor is neither a rate nor a price, but an estimate of the offered rate. As such Libor cannot be manipulated! This fact is important: The Libor is not the price or rate at which inter-bank loans are transacted, but rather the offered or bid "price”, a benchmark around which actual prices are negotiated. The importance of this Libor defect has now been recognized and the British Banker’s Association (BBA), which is responsible for the Libor system of rates, is considering how to capture and publish the actual traded prices.

A second defence is that there are many quoted Libor rates. It is not clear which of these rates Barclays was supposed to have manipulated. Barclays does not set the rate. It together with many other banks submits figures to Thomson Reuters on a daily basis. Reuters then "crunches” the numbers and, on behalf of the BBA, publishes the Libor rate at 11am each day.

Inside the "black box”

Data from around 18 banks is involved, though not all of it used. It is unclear what, if any, influence a single bank has on the published rate. And it is certainly not clear how Barclays, just one of 18 banks contributing data to a "black box” process, could manipulate Libor.

Thirdly, as I have already indicated, actual prices are determined by information. It was known for a long time that there was something wrong with the Libor rate. As far back as 2008 the Wall Street Journal published an article expressing doubts on the Libor. 

The American New York Fed knew there was something wrong with the Libor too, as did the IMF and Bank of Settlements. The American authorities and the Bank of England were exchanging emails on the Libor at the same time. So everybody had doubts about the Libor during the crisis period.

Traders, who on a daily basis trade inter-bank loans, make their decisions on all available information and not only the published data. To believe that trades take place only on published data is to believe shares on the stock exchange are traded only at the published price. What happens is exactly the opposite. 

The published data reflects the traded data. The published Libor rate may be a factor, but is not in any sense an exclusive factor in setting actual prices. It is only a benchmark. We conclude that the published rate had only a limited impact on actual trades, and even less of an impact after it became clear it was suspect.

Impact of the financial crisis

In accusing Barclays of manipulating the Libor rate the financial crisis is completely forgotten. The daily publication of a Libor rate may make sense in a stable market, but it does not during times of crisis. Starting early 2007 and continuing to 2010 markets, on a daily basis, had to process disastrous news of bank failures, bailouts, forced mergers, multibillion dollar write-downs, credit freezes and the collapse of the inter-bank system, to name a few.

A recent book on the crisis contains 65 pages of events over the period. It is naive to believe any of the banking systems worked normally during this time. The entire world banking system was at risk and we can only marvel that governments and financial policymakers, by throwing billions of dollars at the system, prevented its total collapse. The tremendous work done by banks and the Bank of England to pull the UK banking system back from the brink has not yet been acknowledged.

Incorrect assignment of risk

Barclays never attempted to manipulate the Libor rate itself. What it and the Bank of England noticed was that the Barclays rates were at the top of the submissions table. It is widely accepted that interest rates reflect risk. If Barclays was at the top end of the table it meant that Barclays was in fact a higher risk than other banks.

Now bear in mind that Northern Rock, RBS, HBOS and others had all failed and were taken over by the British government or forced to merge. These banks were submitting rates below Barclays. So Barclays as a point of fact had to decide whether or not it was indeed a higher risk than the failed banks. If not – as was the case – they should have taken steps to ensure they fit in the correct place in the table, below the failed banks.

A capital-raising exercise

The Libor submissions were not showing the correct risk rates. To show a higher rate would indicate to everybody, including possible investors, that Barclays was in difficulty and needed to be bailed out, as other banks lower in the table had had to be. Barclays had written down billions and was attempting to raise an additional $12bn capital in Abu Dhabi.

Why would anyone invest in a bank which by its own submissions was a greater risk than already failed banks? It seems to me the management of Barclays and the Bank of England, having decided that either Barclays’ submissions were wrong or Libor was wrong, should have issued instructions to lower their submissions below the failed banks, to correctly reflect their risk ranking. A decision to correctly rank the rate does not affect the Libor rate, but only the risk ranking in the submissions table. (The submissions float around and with the actual published Libor rate).

On the face of it I am unable to fault Barclays’ other than to say I do not understand why the Bank of England did not insist Barclays’ submissions be lowered to correctly reflect their relative risk compared to other banks. It seems nowadays regulations prevent managers from managing and regulators form regulating even if it means preventing a melt-down of the banking system. We live in strange times.

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