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October 20, 2014

What Is That Libor Thing Anyway?

Last summer, hardly a week went by without news concerning another major bank paying a price for involvement with "Libor." Now that the news on the subject has quieted down, it is a good time to catch up and review that the "Libor scandal" is all about.

Introduction. "Libor" means the London interbank offer rate. It is a floating interest rate recalculated every business day. Libor is calculated for loans of several different maturities, such as overnight, thirty days, and 12 months. The structure of Libor was set out in the first Libor loan, made in the early 1970s, when a group of banks in London made a floating rate loan to the national government in Iran (this was before the Ayatollahs). The lead bank asked the participating banks to report their cost of money, that is, what each bank thought it would have to pay to borrow a certain amount of money for a certain period of time. The lead bank averaged their rates and named it the London interbank offer rate. Libor formed the benchmark rate, and the interest rate on the loan was Libor plus an annual percentage rate.

In succeeding years, the Libor procedure was used more and more widely as the basis for floating interest rate loans. Libor was considered to be a reliable benchmark because the benefit to participating banks from attempting to manipulate the average was thought to be too small to be worth the effort.

The Scandal. In the financial crisis and collapse of 2007-2008, Libor spiked because banks were afraid to lend to each other. At least one bidder, Barclays Bank, was concerned that, if the real interest rate it had to pay was made public, the public would panic and there would be a run on the bank. So it reported a bid lower than its true cost of money. In 2007, employees of that bank contacted bank regulators in the United Kingdom and the United States, voicing their concerns that the bank was significantly understating its true costs of funds. Interestingly, its regulator in the UK encouraged the bank not to raise its bid.

Although neither Barclays Bank nor the bank regulators made any statement to the public regarding whether LIBOR was being understated, news leaks during 2008 caused the financial markets to worry that Libor was no longer representing actual market interest rates. Bank regulators in the US and UK were drawn into investigating and reviewing the electronic records of the bank employees who posted Libor estimates. Understating Libor to prevent a run on the bank was bad enough, but in the bank employees' e-mails and texts the bank regulators found a far worse problem. The regulators supposedly found evidence that, at some of the banks, employees had been regularly and systematically changing their Libor estimates in collusion with traders and with other banks in order to increase profits from interest-rate swaps and other derivative instruments.

Because the effect on the Libor average, although small, was enough to make interest-rate swaps more profitable, the bank employees whose job it was to enter into the interest rate swap contracts (traders) contacted other bank employees whose job it was to offer interest-rate estimates for calculating Libor, and encouraged those employees to adjust their estimates up or down, depending upon the traders' current market positions. These contacts between employees frequently took the form of text messages and e-mails in which the writers stated, in so many words, that they were exaggerating their Libor estimates up or down in order to make a profit for the bank.

Response. In the United States, swaps and other derivatives are regulated by the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). The CFTC, the SEC, and regulators in the UK threatened to bring legal action against the banks. Among the regulators' legal arsenal were potential claims that the bank employees had misled bank customers who had entered into swaps and derivative contracts with the banks. Since 2012, the regulators have settled with the following banks for amounts ranging from hundreds of millions to one and a half billion dollars, reflecting the size of the Libor market:

Bank  Amount  Date 
Lloyds Banking Group PLC  $370 million  July 2014 
Rabobank  $1 billion  October 2013 
Royal Bank of Scotland PLC  $612 million  February 2013 
UBS AG  $1.5 billion  December 2012 
Barclays PLC  $450 million  June 2012 

The Libor scandal has resulted in some of the few, rare, criminal proceedings against individuals to have come out of the 2007-2008 market crash. Civil class-action lawsuits have been filed against the Libor banks for manipulation of Libor, including claims by municipal governments what were parties to interest-rate swaps based on LIBOR.

Present and future. Although the process of calculating Libor is subject to manipulation, trillions of US dollar loan contracts continue to bear interest rates based on Libor. To solve the manipulation problem, US and UK bank regulators have recommended that a substitute interest rate index be developed that will be based upon actual loan transactions between banks, rather than upon estimates about hypothetical transactions provided by the banks. Proposals include a "side-by-side" approach, where the substitute index will exist at the same time as Libor, new loans will be based on the substitute index, and loans based on the old Libor will mature and expire. It is too soon to tell the likelihood, or timing, of a replacement method.

In any event, lenders should look at the Libor clause in their loan agreements and consider what effect the Libor scandal has on their language.

If you require further information regarding the information presented in this Legal Alert and its impact on your organization, please contact any member of the Financial Institutions & Lending Practice Area.


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