Libor Scandal May Cost Banks $35 Billion: Study

ejazr

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This might develop into one of the biggest banking scandals, important story to watch

Libor Scandal May Cost Banks $35 Billion: Study

The Libor scandal gets more expensive for the banking sector almost by the day.

Banks may end up paying $35 billion in civil damages for manipulating Libor, according to a new report by analysts at Keefe, Bruyette & Woods, an investment bank specializing in financial services.

Relative to the size of the 16 banks at risk of lawsuits in the Libor scandal, $35 billion is chump change. But it will be another blow to the banks' ability to hold enough capital to satisfy higher regulatory requirements in the wake of the financial crisis. And the damage the Libor scandal does to the sector's ability to push back against regulations is priceless.

Among the group at risk are three U.S. banks reportedly under investigation for their role in setting Libor: Bank of America, Citigroup and JPMorgan Chase. KBW analyst Frederick Cannon estimated that JPMorgan may end up paying $4.8 billion, Bank of America $4.2 billion and Citigroup $3.1 billion to settle civil lawsuits over Libor.

KBW analysts warn that they are not legal experts and that such estimates are speculative. Legal settlements are also "likely years away."

These settlements would address only the lawsuits that will almost certainly be brought by hordes of plaintiffs, including cities and states that lost money in interest-rate swaps because of bank manipulation of Libor, a key interest rate often used as an index that affects borrowing costs throughout the economy.

This estimate does not include any penalties the banks might face at the hands of regulators, which could come much more quickly. Barclays, for example, has already agreed to pay $450 million to regulators to settle charges of Libor manipulation. It may still be on the hook for another $4.9 billion in civil damages, according to KBW's analysis.

This estimate comes less than a week after Morgan Stanley figured the banks may end up paying $14 billion in penalties and legal damages through 2014. The two estimates might not be inconsistent -- KBW said litigation may take more than five years to complete, and that the bulk of estimated damages could come at the end of that process.

While $35 billion is a lot of money to most of us, to the banking sector it is relatively small. JPMorgan's estimated $4.8 billion share, for example, would be less than the $5.8 billion estimated loss it took on the "London Whale" trades in credit derivatives. And the London Whale losses hit the bank in a matter of months, while the Libor losses could stretch out over years.
 

ejazr

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Dome more details on how the LIBOR system works and a possible way to reduce the "rate-fixing"

Libor: Three Scandals in One | Foreign Affairs

Governments in Europe, Japan, and the United States are now investigating 16 major banks for manipulating interest rates. In the months leading up to the 2008 financial crisis, many of the world's most powerful financial institutions allegedly worked to keep down the London Interbank Offered Rate. Libor, as it is known, is supposed to be the average rate at which the largest and ostensibly safest banks in the world can borrow from one another. Manipulating Libor allowed traders to rig financial markets to their advantage; in the process, they distorted the actual value of key financial instruments such as credit default swaps, derivatives, and home mortgages.

The scandal has sparked calls from politicians, including Mervyn King, the governor of the Bank of England, for stronger regulation of the world's most powerful banks. But such proposals miss a key point: Price fixing and manipulation are illegal. They have been for a long time. So it is unlikely that saddling financial markets with legal constraints that simply double down on what is already on the books will help. A better solution would go to the heart of the problem. Regulators and market participants should set such benchmark interest rates as Libor in a way that makes them reflect movements in the market, making manipulation impossible.

The fundamental principle underlying floating rates is to allow the market to determine borrowing costs. Customers who borrow on a floating-rate basis, if they are sensible, and institutions that loan money on a floating-rate basis, if they are ethical, therefore expect two things from a benchmark interest rate. First, the benchmark should reflect actual conditions in the financial markets. That means no random fluctuations -- money costs what it is worth. Second, the benchmark rate should not be easy to manipulate. No rational, informed borrower would borrow money at a variable rate of interest and then empower the lender to determine when and how the interest rate changed in the future.

So it is startling that Libor, the financial world's most important number, satisfies neither of these requirements. Libor is computed by the British Bankers' Association (BBA), a powerful trade association based in London that represents more than 250 financial institutions. These banks are located in 50 countries and have operations in just about every corner of the globe. But instead of using actual market rates, big banks estimate the interest rate that they think they would have to pay if they borrowed money from other institutions. That is different than reporting the actual interest rate at which they are really borrowing from other banks.

Each day, the BBA sets Libor rates for 15 loan maturities in ten different currencies. In the case of the dollar, 18 banks submit their hypothetical borrowing costs. The BBA discards the four highest and the four lowest submissions, which is supposed to prevent a small number of anomalous results from distorting the calculation, and then averages the remaining ten to come up with the Libor number. Thompson Reuters calculates all of these rates for the BBA, and then publishes the results, usually around 11:45 AM (CET).

Since the BBA launched Libor in 1986, trillions of dollars' worth of credit default swaps, futures, and other securities have been bought and sold at prices linked to Libor. The rate is a key reference point for the International Swaps and Derivatives Association, the trade organization that creates standards for the derivatives market. Today, the prices of $350 trillion in financial contracts created by the ISDA are tied to Libor rates. So even a miniscule manipulation undermines the integrity of financial markets and distorts the allocation of credit and capital to borrowers and companies.
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