Belmont Club

The Anatomy of a Lie

If someone had asserted six month ago that the London Interbank Offered Rate (LIBOR) was being cooked, what are the chances he would be laughed to scorn as a conspiracy theorist? But in recent days the chairman of Barclay’s Bank has resigned over allegations that the major UK banks were doing just that: fixing the rate.

Barclays was the first among a group of global banks being investigated to reach a settlement with regulators on two sides of the Atlantic over the manipulation of the so-called London Inter bank Offered Rate, commonly known as Libor.

The parties had been understating the rate for years, both in order to make their borrowing rates — and hence their risk seem lower than it was- and to manipulate the interest which they paid their customers. The LIBOR scandal is interesting also because it illustrates how what seems like a conspiracy can operate for an extended period without being detected. One insider explained how it was done:

It was during a weekly economic briefing at the bank in early 2008 that I first heard the phrase. A sterling swaps trader told the assembled economists and managers that “Libor was dislocated with itself”. It sounded so nonsensical that, at first, it just confused everyone, and provoked a little laughter …

What the trader told us was that the bank could not be seen to be borrowing at high rates, so we were putting in low Libor submissions, the same as everyone. How could we do that? Easy. The British Bankers’ Association, which compiled Libor, asked for a rate submission but there were no checks. The trader said there was a general acceptance that you lowered the price a few basis points each day.

According to the trader, “everyone knew” and “everyone was doing it”. There was no implication of illegality. After all, there were 20 to 30 people in the room – from management to economists, structuring teams to salespeople – and more on the teleconference dial-in from across the country.

Even the marketing people were told that “Libor was dislocated from itself”. People trudged along as usual, working their hours, taking their breaks, going on scheduled vacations. Nobody seemed to mind. Even the regulators did not seem to care much. “On April 17, 2008, a senior Barclays manager told the watchdog “that Barclays had been understating its Libor submissions”, admitting that the bank was not “clean clean, but clean in principle”

Everyone seemed to accept the practice as the way things were done. One commenter at the Telegraph remarked that there was no substantive violation because everybody knew there was fudging in the process, so where was the beef? “Bank funding is an arcane science, and the marginal cost of funds (i.e. how much the next £ you are going to lend is going to cost you) is a complex mixture of historical funding rates, … structures in your existing book of business, and qualitative issues.”

But that misses the biggest aspect of the financial crisis.  It’s not OK if everyone does it, if in the process, they are unconsciously distorting their own information base.  If a pilot sets his altimeter compensation to any random number simply because everybody does it, the other pilots may not give a hoot, but the surface of the earth will. Sooner or later his altitude information will get him into trouble.

Insider deals and opaque information have gradually worn down the price signal. In a simple system that might not matter. But a global financial system with signals feeding back on each other it has created huge distortions in value, distortions which are the heart of the current world crisis. Ironically LIBOR itself was created as a benchmark to anchor other financial instruments which in turn depended upon it.

In 1984, it became apparent that an increasing number of banks were trading actively in a variety of relatively new market instruments, notably interest rate swaps, foreign currency options and forward rate agreements. While recognizing that such instruments brought more business and greater depth to the London Interbank market, bankers worried that future growth could be inhibited unless a measure of uniformity was introduced. In October 1984, the British Bankers’ Association (BBA)—working with other parties, such as the Bank of England—established various working parties, which eventually culminated in the production of the BBA standard for interest rate swaps, or “BBAIRS” terms. Part of this standard included the fixing of BBA interest-settlement rates, the predecessor of BBA Libor. From 2 September 1985, the BBAIRS terms became standard market practice.

The rate fixing process introduces a systematic bias into the price signal and after a while things — especially instruments dependent on that price — wind up in a different place. This company for example, is selling a technique that will more correctly measure risk, since the difference between OIS and LIBOR is a measure of the borrowing bank’s risk.

With many of the world’s financial institutions in the process of migrating to new market standards, questions remain as to the potential impact on existing portfolios, as well as how to effectively manage instruments with longer-dated maturities when spreads in LIBOR v. OIS rates begin to diverge

The case study also illustrates that the most significant difference in pricing and risk between the two approaches is most apparent for long dated swaps, seasoned swaps, and off-market swaps. Moreover, as the case study unfolds, we come to see that the single curve approach essentially ignores OIS and spread risks together. The bottom line becomes clear: the mispricing of risk is significant when the spread increases.

Consistent valuation techniques are critical, throughout a firm and relative to the market, with front, middle and back office computational consistency a necessity. Without this consistency, market quotes and counterparty valuations will diverge, risk calculations will differ between departments, and correct hedging decisions will be compromised.

But if one the variables in their equations is rigged, and rigged for a long time at a value different from the true rate then error increasingly accumulates within the financial system.  The blind lead the blind. No quantitative model can fix bad inputs. The net result of dishonesty in the financial system is that parts of it become grossly overvalued and other parts vastly undervalued. The price distortion inevitably drives resources into the wrong places and money into the wrong — or shall we say right — pockets. It also sets up a system crash.

The financial system can be regarded as a vast database which stores the past, present and future values of “real world wealth”. But operations on a database — any database — can only be safely performed if the data is left uncorrupted; and if the reconciliation process has integrity. But if transactions are routinely and intentionally writing the wrong values into the database it eventually diverges from the objects which it purports to represent. At some point the database becomes effectively worthless. In a financial system this creates a giant element of risk that shakes it to its foundations.

The rise of centrocratic systems allied to global, complex systems has allowed bubbles to arise on a vast scale. The political, financial and cultural datastores of Western civilization are now massively corrupted: the tame media creates fake politicians, the financial system blows up inflated assets and worthless political correctness creates societies that are doomed to die. The coin of information has been debased and we shall all be paid back in it.

And how did it happen? Because everyone thought that was the way business had always been done. The junior staffers at the banks unquestioningly took orders from their seniors. And the seniors unhesitatingly served themselves. On it went. In a sense there was no criminal conspiracy; no secret meeting in a smoke filled back room. There was only a tacit acceptance that the system was too big to fail and they could do anything they wanted. It was not. And how painful the realization will be.

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