If you were listening to Marketplace Morning Report this morning -- and you should have been, because it's a great show -- you might have heard my piece this morning on LIBOR.
LIBOR, if you're an avoider of acronyms, is an important interest rate that is set by banks. It's not exactly...scientific. Essentially, 18 international banks get together each morning and report what other banks would charge them if they asked to borrow. This explainer can walk you through how it works.
The self-reported nature of LIBOR is important, because it means banks could fudge on it without being called out. Think of it this way: imagine that you had to take a survey of what you weighed. Most people would fudge a little to make themselves look better. That's what banks did with interest rates during the financial crisis.
Everyone knew this. I talked to Joe Gagnon, a senior fellow with the Peterson Institute for International Economics, for some perspective on what the Federal Reserve knew, back in 2008, when it tipped off British banking regulators that banks may have been widely manipulating LIBOR.
The big question on everyone's mind is: If U.S. and U.K. officials suspected something was amiss with LIBOR, why didn't they do something about it four years ago, instead of largely ignoring the big scandal until now?
It may come down to the description of what, exactly, the banks were doing. How were they manipulating LIBOR? Were they just lying outright? Were they fudging the numbers a little? Or was there something more subtle going on?
Gagnon was at the Fed in 2008 when it investigated the LIBOR charges. What the central bank found was that it was inconclusive whether banks were actually lying. But, as Gagnon said, they likely had a gentleman's agreement to cover for each other as they under-reporting the interest rates they were truly paying.
Here's how Gagnon described it:
The banks were uncomfortable. They don't want to report being charged a high rate, because that says that someone out there doubts them.
So we looked into it and asked the market participants. We couldn't rule out there was actual lying about the rate, and that's coming to light now. But what we heard was there was a sort of collective agreement of many banks to cover for each other in the following sense: that they would agree to lend [each other] money at a low rate or a reasonable rate - but only on the implicit condition that they actually wouldn't ask for very much money at that rate. So if you wanted a few million - and that's not very much for these huge banks - they were willing to lend at the rates they were reporting. So they weren't lying. But if they actually needed a significant loan - say, in the hundreds of millions - that wouldn't be possible. They would be charged a much higher rate. And they didn't report that. And of course the rules for LIBOR didn't say how big the loans had to be. These were just hypotheticals and it was just stated as "how much could you borrow at?"And that was a problem.
Now, there was an investigation by the British Bankers' Association at the time, which claimed to find only minor irregularities and proposed...they basically shook their finger at some banks that they suspected of not being truthful. But it didn't really impose any harsh penalties at the time.
You can hear some of Gagnon's comments here.
That's pretty damning stuff. It suggests that, during the crisis, banks probably agreed on their own form of LIBOR -- one that violated the spirit, and maybe the letter, of the way the interest rate should be set.
If there's proof, it's a form of collusion, and a potential antitrust case. Mastercard and Visa just experienced the full force of the government's wrath on that kind of case, and it's not pretty.
Bloomberg News also has a theory. After talking with traders, the news organization reported today that some traders knew they could manipulate LIBOR by just under-reporting their own interest rates, without resorting to calling other banks.
Either way, the discovery of how LIBOR was manipulated - which is what regulators are studying only now - may be the best, most illuminating look at Wall Street culture - and how regulators and banks could end their stupid game of cops and robbers and blathering about "confidence" and "trust" and actually work to improve the honesty in the financial system.