Times' Rana Foroohar: How Barclays Rigged the Machine

In an excellent article, Time Magazine's Rana Foroohar reviews the Libor scandal.

LIBOR is a measure of banks' trust in their solvency....

As in, the trust a bank with deposits looking to invest has in the solvency and ability to repay a loan of a bank looking to borrow.  The less trust, the higher the rate the borrowing bank has to pay.

The Financial Crisis Inquiry Commission highlighted the problem was that in 2008/2009 the banks could not determine which banks were solvent and which banks were not.  As a result, banks could not trust that they would be repaid and the interbank lending market froze.

Around the time of the financial crisis of 2008, Barclays' rate was rising. 

If a bank revealed publicly that it could borrow only at elevated rates, it would essentially be admitting that it--and perhaps the financial system as a whole--was vulnerable. 

So Barclays gamed the system to make the financial picture prettier than it was. 

The charade was possible because LIBOR is calculated not on the basis of documented lending transactions but on the banks' own estimates, which can be whatever bankers decree. 

This Kafkaesque system is overseen for bizarre historical reasons by an association of British bankers rather than any government body....

The reasons are not bizarre.  The banks wanted the opacity of the Libor system so they could collude on pricing.

As many as 20 of the world's largest banks are being sued or investigated for manipulating over the course of many years the interest rate to which $350 trillion worth of derivatives contracts are pegged. 

Bank of England and former British-government officials accused of colluding with Barclays to stem a financial panic may also be caught up in the mess..... 

Unlike the JPMorgan trading fiasco of a few weeks ago, which has resulted in a multibillion-dollar loss, the only apparent red ink so far in the LIBOR scandal is the $450 million in fines that Barclays will pay to the U.K. and U.S. governments for rigging rates (though pension funds and insurance companies on the short end of LIBOR-pegged financial transactions may have lost a lot of money). 

Either way, the truth is that LIBOR is a much, much bigger deal than what happened at JPMorgan. Rather than one screwed-up trade that was--whether you like it or not (and I don't)--most likely legal, it represents a financial system that is still, four years after the crisis began, opaque, insular and dangerously underregulated. 

"This is a very, very significant event," says Gary Gensler, chairman of the U.S. Commodity Futures Trading Commission (CFTC), which is one of the regulators investigating the scandal. "LIBOR is the mother of all financial indices, and it's at the heart of the consumer-lending markets. There have been winners and losers on both sides [of the LIBOR deals], but collectively we all lose if the market isn't perceived to be honest."...

Please re-read the highlight text as it confirms what your humble blogger has been saying about opacity for the benefit of the banks having been allowed to develop in large segments of the financial system.

One tragic and underappreciated consequence of the LIBOR rigging is that it helped mask the brewing financial crisis. To the extent that we couldn't clearly see from rising LIBOR numbers that banks were losing trust in one another, we were denied an important red flag in the run-up to the crisis. 

That lack of transparency is one big reason Gensler and others say the first step in fixing the LIBOR problem is to base the rates on actual transactions rather than banks' fuzzy estimates.

Please re-read the highlighted text again as it is nice to have Mr. Gensler and others, like Sir Mervyn King, championing transparency.

Regular readers know that transparency into the actual transactions is inadequate.  What is needed is ultra transparency under which the banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

This level of transparency is needed so that banks with deposits can independently assess the risk of each bank that is borrowing money on an on-going basis.  This is needed to unfreeze the interbank lending market and to keep it from refreezing.