Both pictures are right. The first wrong-doing, motivated by individual profit, occurred between 2005 and 2008. The second, now corporate misbehaviour, started when the current financial difficulties began to bite in late 2007 and it went on until 2009. Barclays has been fined heavily for its part in this scandal, but other banks were involved too.
There are several London Inter-bank Offered Rates, and placing a value on each would be easy if there was always a functioning market. But Libors are needed even when the market is illiquid and there is little or no inter-bank lending that day, as is often the case. This leaves two possible approaches. Revealed preference methods deduce the value of a quantity from people’s actions, following John Locke’s precept: “I have always thought the actions of men the best interpreters of their thoughts”. The less secure alternative used for Libor is stated preferences. These run the risk of the person adjusting his response to his own advantage. As we know now, at least some submitting bankers distorted their estimates deliberately over a period of at least five years.
Libors, benchmarks for interest rates globally, are referenced in transactions with a notional outstanding value of $300 trillion. Together with the similarly compromised Euribor (Euro Inter-bank Offered Rate), Libors determine the payments for both over-the-counter interest rate derivatives contracts and exchange-traded interest rate contracts, not just by the large financial institutions but also by public authorities and small businesses. Their influence extends to mortgages and bank loans.
Libors are calculated by taking the typically 16 views offered by different banks, discarding the top four and the bottom four and averaging the remaining eight. But the analyst is entitled to downgrade or discard opinions only of those he knows in advance to be unlikely to provide a reasonable view – the insane, those without relevant knowledge or experience and those trying deliberately to subvert the exercise. The rest of the people in the survey should be treated on an equal-rights basis, with everyone’s opinion accorded the same respect. For who is to decide which views should be given higher weightings? Not the analyst, who will not know the correct valuation until he has finished his analysis. Not the other participants, who would give high weightings to their own and similar views, and low weightings to everyone else’s.
This is the other problem with Libor. The only way to protect against a charge of favouritism is for the analyst to use the unvarnished sample mean: exclude nobody’s view and calculate the simple average. Using its relative size rather than its likelihood a priori of being correct as the basis for discarding any view violates the criterion of structural view independence, which requires impartiality to be built into the method for analysing human opinions.
The distorting effort on Libor of excluding outliers was revealed after Bloomberg published an article in September 2007 identifying Barclays’ Libor submissions as exceptionally high and questioning Barclays’ credit worthiness as a result. In fact, high inter-bank rates were actually realistic in the stressed financial conditions of late 2007, but such views were excluded from Libor as outliers, almost certainly depressing its value in consequence. Then after the Bloomberg article, Barclays lowered its Libor submissions to fit in.
Unfortunately, the Wheatley Review decided to stick with stated preferences and retain the practice of discarding half the sample through double-sided 25 per cent trimming, even though this provided no protection against the previous Libor manipulation, and may, indeed, have contributed to it.
But the use of stated preferences to estimate important financial parameters like Libors is problematical, especially when the banks had, and presumably have, incentives to falsify their opinions. The hunt must surely be on to find a safer, revealed preference technique for estimating Libors without the risk of rigging in the future.
Philip Thomas is professor of engineering development at City University
