Libor liars

Friday, June 6

Hundreds of billions of dollars worth of corporate debt, mortgages and derivatives are in some way pegged to the London Interbank Offered Rate, or Libor – a benchmark that represents the cost of borrowing.

Yet Libor's legitimacy has been called into question:

• The Bank of England last November published minutes suggesting that the actual cost of inter-bank borrowing was greater than Libor suggested.

• In March, the Bank for International Settlements (BIS) suggested that Libor rates might have been influenced by banks understating their borrowing costs to appear financially healthier than they were.

• The British Bankers Association (BBA) -- which oversees the daily benchmark setting process -- in April announced that it was bringing forward its annual review of the process.

As the credit crunch and vanishing liquidity gripped financial markets in August 2007, three-month Libor hit 2.4% -- its highest level in almost 20 years. Irregularities with Libor have been apparent since then, perhaps showing that banks have been submitting artificially low rates.

The rationale for such manipulative behaviour is clear. A low rate indicates to the market that a bank's peers do not view it as a particularly risky counterparty, facilitating easier borrowing. Suspiciously, some institutions which suffered major writedowns have claimed they could borrow much cheaper than institutions with less battered bank balance sheets.