What is Libor?

Ya but why do banks lend each other?

How do banks borrow in London?
Who calculates LIBOR?
How does BBA calculate LIBOR?
Why does BBA calculate LIBOR?
Whatre the Implications of LIBOR
Why LIBOR scam?
What is Barclays?
Wrong Data= Wrong Average
Timeline of Events
What the hell is Libor?
Suppose SBI and BoB (Bank of Baroda) are London based Banks.
If Bank of Baroda borrows money from State Bank of India, say 1 crore pounds
for 1 month @12% interest rate.
Then 12% is the London Interbank Offered Rate (Libor).
In short, LIBOR= the interest rate at which banks borrow and lend from each othe
r in London. (i.e. SBI is lending @12% and BoB is borrowing @12% interest rate, but
either way the interest rate is 12%.)
But this is a technically not so correct definition. Because there ought to be m
ore than two banks in whole London and all of them cant be lending to each other
at the same interest rate, right? Well come to that problem very soon but first o
f all.
Why the hell do banks lend each other?
In every country, there is one RBI (Central Bank) and there are some SBIs,B
oBs etc. (Commercial banks). Usually, the SBIs take deposits from customers and
some loans from RBI and lend this money as home/car/bike/business/personal loan
to other customers. So why do these banks need to borrow from each other?
Well, there are days when more customers have made withdrawals than deposits
. (e.g. before Diwali / Christmas or IPL cricket betting) so a Bank has to borro
w from its rival banks to cover the shortage of cash. It is not necessary that
a bank is running into losses and hence borrowing from the other banks. Because
a bank would have loaned the money to other customers for 5-10-20 years period s
o it cant immediately recover all the cash in one day.
On the other side, banks with a cash surplus can make extra profits by lendi
ng its cash to a rival bank.
Thus, Banks lend to each other on a short-term basis to either to cover the
shortage of cash or to make a profit.
How do banks borrow each other in London?
When you want to take car- loan, you visit various bank branches, take their
brochures, if youre tech-savvy you might just visit the website of all famous ba
nks and compare their interest rates, loan terms etc. So, there is total transpa
rency about interest rates,
But when one bank has to borrow from another bank, such transactions take pl
ace via phone-conversations between their executives, there is lot of give and t
ake, bartering etc. for example-
if your bank promises not to setup any ATM booths around Gujarat univers
ity for next five months and ill reduce the interest rate!
another case
I know your 20,000 crores rupees are stuck in the loan given to that Mal
lya. So youre in no position to negotiate. Give me 18% interest else I wont offer
any loan.
In short, there are many variables and behind the curtain deals.
We can know the buying and selling price for shares of Infosys by glancing a
t the Nation Stock Exchange website/ screen/ CNBC or similar business news chann
els.
However, there is no comparable screen where we can learn the LIBOR.
For the last 26 years, the British Bankers Association (BBA) has computed Lib
or by asking dealers what they saw as prevailing market conditions, deleting the
high and low values of the reports, and taking the average of rest data.
Who calculates LIBOR?
It is calculated daily by British Bankers Association. (BBA)
How does BBA calculate LIBOR?
Every day, 16 banks in London, will send SMS to the BBA Manager, giving the
the interest rate that they are charged to borrow money.
The BBA manager will delete the four highest rates and the four lowest rates
. And then hell take average [mean] of the remaining data.
Thus, The average of the eight remaining rates = Libor rate.
Why does BBA calculate LIBOR?
If a bank is weak and unlikely to repay money on time then the rival banks w
ill demand higher interest rate while lending money to that weak bank.
Means, A bank has to pay a higher interest rate to borrow funds if other len
ding banks have less confidence in it.
So, The rate each bank has to pay is in part a reflection of their rivals per
ception of its financial strength, effectively how much it is trusted.
This means that the Libor rate gives an indication of the health of the wide
r banking sector.
Euribor=plays the same role for banks based in the eurozone.
SIBOR =for Singapore
HIBOR=for Hongkong
Whatre the Implications of LIBOR
In UK, the Banks charge interest rate on home loans according to LIBOR. If L
IBOR increases then home loan interest rate also increases.
Even in USA, majority of the home loans were linked to LIBOR rate (in 2008).
Same case for business loans.
Same case for students (education) loans.
Many Futures and derivative contracts in forex, commodity and oil market are
based on LIBOR rates.
In short, The prices of trillions of dollars worth of financial transactions
around the world are set according to Libor.
Indirect implications are many (both positive and negative), for example, If
a businessman in US or UK has to pay more interest rate for getting loans,
He may increase the price of his products.
he may reduce the number of employees or
he may be outsource the work to India and Philippines to reduce the operatio
nal costs.
he may scale down his operation, thus reducing the amount of raw material /
input products imported from India. and so on
Why LIBOR scam?
Recall the earlier statement: A bank has to pay a higher interest rate to bor
row funds if other lending banks have less confidence in it.
If youre Managing Director/CEO of a Bank, you wouldnt like to report the highe
r interest rate of borrowing. Because that means other banks have less confidenc
e in you. Imagine what consequences it can bring?
The aam-juntaa would still keep coming to your bank as long as you hire cele
brities to do the advertisements.
But, The big corporate houses, have wise Chartered Accountants, who understa
nd the meaning of such numbers and its long term consequences. So, CA may advice
his CEO to close the companys bank accounts and deposit money in other banks.
Some big Companies may even stop taking loans from you.
The price of your shares, go down in the sharemarket, because investors lose
faith in your bank.
And with all this mess, the Board of Directors may remove you from your CEO job
and hire a new CEO to fix the bank.
What is Barclays?
Barclays is the name of a British Bank.
It is the fourth-largest of any bank worldwide (First three banks are: BNP P
aribas, Deutsche Bank and HSBC)
On a side note, if we make list of Top 50 banks of the world according to th
e cash theyve, then there is no bank from India.
Anyways, coming back to this Barclays Bank.
Recall the sub-prime crisis, Barclays, along with many other banks had given
loans to plenty of unworthy customers in US, who didnot have the aukaat to repa
y the loan. Barclays money was stuck in USA around 12 billion dollars worth of to
xic assets. So Barclays situation was bad, the other rival banks of London, knew
it and they didnot have much confidence in this bank.
But even during this period, Barclay [and other 15 banks in London] had to s
end daily SMS to BBA Manager so that he could calculate the LIBOR.
So, Barclays CEO Mr.Bob Diamond sent artificially low figures to BBA manager,
in order to hide the fact that his bank was in a mess.
Bob Diamond says whaat an idea sir-ji
[recall the concept : if bank X has to pay more interest for borrowing from
another banks compared to bank Y, that means Bank X is weaker than Bank Y.]
Its not that Bob Diamond himself sends fake SMS from his Nokia 1100, theyd hav
e pretty sophisticted email or software system and dedicated staff for doing all
this, but the Barclay staff will not dare to send wrong data to BBA, without th
e secret consent and approval of Main boss.
flipkart pay on delivery
It doesnt mean that Barclays is the only villain in this episode.
Some of the Other 15 banks of London also misreported their borrowing rates, why
?
Because, During the global financial crisis (2007 and afterwards) the RBIs (
Central Banks) in developed countries (like UK, France and US) had started givin
g loans to their nations banks at very nominal or close to 0% interest rate in or
der to boost the economy.
So the various banks in London, also got cheap loans from RBI of UK (known a
s Bank of England).
Now their CEOs had incentive to to quote higher than usual rates of borrowin
g because if LIBOR went up, then their banks could earn more interest on Libor-l
inked loans.
If LIBOR rate was manipulated even by 0.01%, then these banks could make a a
bout a couple of million dollars more in the interest rate charged on home / bus
iness loan customers.
So, Barclays is not the only villain this scam, just like A.Raja is not the
only guy in 2G scam.
Side-Question: if the banks in London are getting cheap loans from their RBI
, then Barclays should also have recieved some loans from their RBI @0%, right?
yep, but Barclays was in bigger trouble (12 billion dollars) than the amount of
money their RBI could lend to fix the mess.
It is also alleged that Barclay staff also coordinated with staff from other
banks to jointly report the false data to BBA. [Because these people had invest
ed in various futures/derivative contracts whose payment depended on LIBOR rate.
]
Wrong Data= Wrong Average
You already know that BBA manager will receive 16 SMS every morning, hell rem
ove the top 4 and bottom 4 values and take average of the remaining values and p
ublish that number as LIBOR rate for that day.
If even a single SMS [value] is incorrect, then hell get a wrong average [LIB
OR].
In our case, Barclay is reporting lower than usual, while some other banks a
re reporting higher than usual, so overall the Average (LIBOR) increased.
So all these years, BBA manager was publishing wrong LIBOR, because he wasnt
getting the right data from Barclays and other banks.
And because of the Wrong LIBOR rate, the UK and US citizens had to pay highe
r interest rates on home, student and business loans [because their banks set th
e home/education/business loans interest rates according to LIBOR rate]. Similarl
y investors in Forex, Commodity etc. market ended up paying more than necessary
money for the contracts, because their contracts were linked to LIBOR.
Timeline of Events
2008 The Wall Street Journal (WSJ) published an article on this activity of s
ending wrong data.
2011-2012 U.S. Department of Justice conducts a criminal investigation int
o Libor abuse.
Jun 2012 Barclays Bank was fined $160m by the United States Department of
Justice, $200m by the Commodity Futures Trading Commission, and 59.5m by the Fin
ancial Services Authority for attempted manipulation of the Libor and Euribor ra
te.
July 2012 CEO of Barclays, Mr.Bob Diamond, resigned.
August 2012 Innocent aspirants of UPSC, Bank and MBA are forced to learn one
more topic for the exam.