The LIBOR scandal: What it is and why you should care

The London Interbank Offer Rate, commonly known as LIBOR, was manipulated by Barclays and that should make you angry. Most people have no idea what LIBOR is, but it has a major impact on the lives of most Americans. LIBOR is the average interest rate that large banks in London charge to one another to borrow money. The rate charged between banks in London turns out to be the basis for the interest rates on more than $350 trillion in loans and derivative contracts. And, the rate impacts the interest rate we pay on everything from adjustable rate home loans and auto loans to credit cards and almost all other kinds of credit.

Eighteen large, London-based banks daily report their cost of borrowing to the British Bankers Association; those values are averaged and then LIBOR is published. If the rate the banks report is high, it means either (1) that interest rates are high or (2) that lending money to the bank is perceived as risky because of its potential for default. Recently, Barclays admitted to lying about the rate it was being charged to borrow money, and the bank paid a $453 million fine to U.S. and British government authorities for doing so. At first Barclays claimed that it lied about manipulating LIBOR because the bank did not want to admit that other banks were afraid to lend Barclays money. But now there is evidence that potentially many banks were lying about their actual borrowing costs so that they could profit on derivative trades where payoffs are dependent on the level of LIBOR. That the very banks that set LIBOR also get to trade derivatives tied to the index, well, that is what we call “letting the fox guard the hen house.”

You should be angry because it appears that Barclays is not alone in manipulating LIBOR; in fact, the practice was a bit of an open secret among many banks. Sometimes these manipulations saved you money by lowering your interest rates. Longer term, these manipulations make our credit markets less efficient and result in higher overall rates for everyone. The one positive note is that the U.S. Department of the Treasury is taking the lead to clean up the way this important interest rate measure is calculated. It’s nice to see the United States taking the lead, at least in this instance, in making sure that the public is treated fairly.

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