What's Up With Libor?

A blog about business and economics.
July 5 2012 11:31 AM

What's Up With Libor?

I've been remiss thus far in not adequately covering the Libor scandal brewing in the United Kingdom but with global implications.

The basic point here is that Libor is really two different things. It stands for "London Interbank Offer Rate," meaning the interest rate that banks charge each other for short-term loans. That's a number, and it matters because sometimes banks need short-term loans. But it's far more important as a benchmark, where all kinds of interest rates (for credit cards, student loans, some mortgages, etc.) are pegged to Libor.

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The scandal emerges at the confluence of the two.

In theory, the way this is supposed to work is that banks' actions determine Libor based on considerations of the interbank lending market. Then, separately and unrelatedly, the output of this is used as a benchmark in a lot of other contexts. But precisely because the Libor benchmark is so widely used, knowledge of where Libor is going can be helpful in a huge range of financial activities. And yet the very same banks whose interbank lending activities determine where Libor is going also have trading desks who can profit from knowing where Libor is going. The scandal is that banks—most of all Barclays—were taking advantage of this arbitrage opportunity and screwing around with Libor in order to benefit other aspects of the business. I'm not an expert on U.K. financial regulation, so I have no idea what the legal consequences of this will ultimately be, but on the level of norms and behavior, it's the absolute destruction of a core element of the system.

Whether any class of people was systematically damaged by this seems unlikely to me since the manipulation went in both directions at various times, but by the same token huge numbers of people and institutions around the world will have lost money due to this. But the biggest element is that it's a catastrophic blow to the credibility of the financial structure, suggesting that one of the main purposes of assembling large "universal bank" enterprises is just to make it easier to rip people off. It seems—rightly—to have led to an upsurge of calls in the Financial Times and other unlikely places for another look at radical reforms to the existing structure of banking.

Matthew Yglesias is the executive editor of Vox and author of The Rent Is Too Damn High.