Regulators in the dark as the sun sets on LIBOR

In 2019, the United Kingdom‘s Serious Fraud Office (SFO) angered many people who had hoped the agency would identify and punish more bankers responsible for one of the world’s most notorious cases of financial manipulation. Instead, the SFO quietly ended its seven-year investigation into the rigging of LIBOR (the London Interbank Offered Rate). Now bankers are scrambling to find a risk-free LIBOR replacement.

“This is yet another instance of banks’ reckless and potentially criminal behaviour going almost entirely unpunished,” said David Clarke, head of policy and advocacy at Positive Money, a London-based research and campaign group.

The LIBOR scandal saw traders game the international financial system out of trillions of dollars by manipulating a key banking benchmark. Their collective misdeeds affected everything from credit cards to mortgages and government borrowing. Making matters worse, several investigations show regulators knew about the manipulation, let it continue, and failed to prosecute senior figures even as evidence of deep cultural flaws emerged.

In the new year, several LIBOR alternatives will vie for the top spot, but it remains to be seen whether the banking benchmark that finally gains the world’s acceptance will be manipulation proof. And the clock is ticking, because international regulators have called for LIBOR to be replaced by the end of 2021.

The scandal

LIBOR has been a benchmark interest rate since the 1980s. Roughly $300 trillion worth of financial products are tied to the LIBOR rates for the United States dollar. Loans for students’ tuition, for home purchases and even for corporate and government debt are in part based on LIBOR.

For most of its life, LIBOR was an entirely self-policing system, relying on bankers’ honesty and no real administrative oversight. Every day, global banks on a LIBOR panel were asked to submit rates they would expect to pay to borrow from other banks that day.

Crucially, banks were not asked to submit what they actually paid to borrow, and so LIBOR was essentially based on whatever number banks choose to offer up: an in-built incentive to cheat. Making matters worse, regulators did not check the bank-supplied numbers against past transactions – a system Clarke describes as “inherently dysfunctional”.

The inherent dysfunction was only addressed in 2016, when the Intercontinental Exchange began to administer LIBOR with a tighter methodology to limit reliance on bankers’ honesty. Banks’ submissions were checked by an external regulator, against market transactions, but banks’ own “expert judgement” still played a fundamental role in setting LIBOR rates, so elements of the problem still persisted.

It took seven years to achieve those reforms after Barclays bank admitted to rate manipulation in 2012 and was fined $400m in the US and UK. Between 2005 and 2007, Barclays rigged its submissions hoping to help its investment trades. It also admitted to rigging its rate submission between 2007 and 2009 to appear more financially secure than it really was.

Initially, banks suggested that the scandal was the result of a few rogue traders rather than an endemic lack of oversight or regulatory failure. However, when six other banks were implicated in the rigging scandal, it became clear that the practice was commonplace.

Prosecutions fall short

In the first wave of LIBOR cases, five Barclays traders were convicted and sentenced to between four and 11 years in jail. But the next phase of prosecutions was less successful, and in the end, the SFO’s seven-year probe yielded some 400 million pounds ($529m) in fines – and eight acquittals.

Some of those charged claimed they did not believe they were breaking any rules, insisting that the internal culture at banking institutions, coupled with a lack of regulatory oversight, seemed to encourage their actions.

Neil Williams, legal director at London law firm Rahman Ravelli, regularly represents bankers in cases brought by the SFO. He told Al Jazeera that “the number of acquittals bears out the idea that it was condoned at the time”.

A 2012 US Commodity Futures Trading Commission report found a culture at Barclays where misconduct was “common and pervasive” and noted that “traders would often shout across the trading desk … to confirm there were no conflicting requests [to rig submissions differently].”

A 2017 BBC investigation published an audio recording of a manager telling a trader there was “very serious pressure from the UK government and Bank of England about pushing our LIBORs lower”.

Evidence around the LIBOR scandal implicated figures far more senior than those charged. Email transcripts published in 2012 showed a chain of contact from a senior figure in the UK Civil Service, to the deputy governor of the Bank of England, on to Bob Diamond, then-CEO of Barclays.

Williams says that while SFO investigations may include senior figures early on, “those who ultimately direct and control” banking operations – and who therefore set the culture in banks – are often smaller players whose cases are pursued in court.

Cozy relationships between regulators and bankers who were manipulating LIBOR were not limited to the UK. According to court filings, Barclays traders openly acknowledged LIBOR rigging to Federal Reserve Bank of New York analysts by phone and email in 2007 and 2008, but no action was taken.

Despite reports and apparent evidence of wrongdoing by senior figures, the SFO probe never saw action taken at higher levels. Williams says this is commonplace, with probes focusing on those “who might be deemed lower-hanging fruit”. Lower-ranked employees, he said, often “find themselves in the firing line once the allegations gain substance”.

LIBOR replacement

LIBOR is due to end in 2021 when the current commitments of contributing banks expire, but financial firms do not seem to be rushing to choose a new benchmark. In June, the UK’s Financial Conduct Authority sounded a warning that banks were delaying their preparations to transition away from LIBOR.

Banks argue that training is expensive, and operational complexity prevents them from moving more quickly to replace the troubled banking benchmark.

Several alternatives are competing to take LIBOR’s place. The Bank of England recommends the Sterling Overnight Index Average (SONIA) as a replacement. The US Federal Reserve, meanwhile, is endorsing the Secured Overnight Financed Rate (SOFR). Both benchmarks analyse the previous day’s trading in different financial markets to set the next day’s rate. But the rates take no notice of banks’ credit risk – the covering of which was a major driver of LIBOR manipulation.

In theory, SONIA and SOFR rely less on bankers’ honesty than LIBOR did because they rely on existing trade data, but Joel Shapiro, an associate professor of finance at the University of Oxford in the UK, doubts these benchmarks will be free of problems associated with LIBOR.

“Transaction-based benchmarks [like SONIA and SOFR] can still be manipulated,” he told Al Jazeera, noting as an example that two or more banks may still collude on the rate, or manipulate it over a longer period or in a greater volume of trades.

“It’s harder,” warns Shapiro, “but there has been no discussion of this [by regulators] …. and the LIBOR transition is going to be difficult.”

Shapiro co-authored a paper that offers another LIBOR replacement – one whose only purpose is “to learn the true borrowing rate, by encouraging banks to put their money where their mouth is”.

Unlike SONIA and SOFR, the Oxford system actively incentivises accurate predictions from banks and puts regulators in the driving seat. Banks’ previous assessments are checked against actual transactions, and any discrepancies flagged. Regulators can then levy fines, in real time, against banks whose rates deviate from the findings.

While the Bank of England and US Federal Reserve describe their proposed LIBOR replacements as “risk-free”, others are less certain. Shapiro said of his own system, “It wouldn’t be perfect, but it would be a lot better”.

Williams agreed when reflecting on an essential truth of modern banking. “The sums involved, the rewards, it’s too great to miss,” he said. “If the carrot is there, rules will be bent.”