The recent Libor and Euribor crisis are the most serious financial problem in the banking sector. They refer to the lowest interest rates that a bank can offer an unsecured loan to another on short term basis without collaterals. For their degree of influence, they are influenced by major players in the banking industry. The two rates, Libor in UK and Euribor in Europe recently suffered manipulation by major banks, for the sake of individual bank gains. The two interest rates are fixed on daily basis, as result, each bank was keen to fix a rate that would benefit its associates, the result of which was detrimental to other banks not favored by the rate. The manipulation trend continued for a number of years, with the peak featuring banks striving to keep interest rates low since they had all the incentives to make the attractive loans cheap. Key financial institutions today blame the regulators to have not done their work, however, the fact that such institutions, for instance, Barclay played major roles and for years is the most critical aspect of the problem.
2007, the onset of the crisis
In the spring of 2007, some associate banks, Bear Stearns, for example, went bankrupt due to catastrophic losses in their mortgage-backed securities portfolio when lender rated mortgage paper “failed”. Before the issue, none of the rated paper had failed, this happened for the first time. During the period, banks availed false borrowing rates to be used in the calculation of rates; this was intended to make banks appear stronger (Daniels, 2014). They lended money at smaller rates and ripped little profits in the markets. As a result, their client, this are the investment vehicles, went bankrupt since they were not getting their portion of the trade as they would in normal business environment, unrigged rates.
As a result of the failing rated papers, credit markets seized up because banks refused to extend credit, even to one another as a result of the forces in the crisis. Libor rates are normally set on daily basis in London each morning by combined effort of reference banks whose sole appointee is the British Bankers Association and the equivalent body in the Europe set the Euribor rates. Libor rates serve as benchmarks, or reference rates from which the associate bank-to-bank loans are set. Eurodollar serve as is a symbiotic proxy for Libor, equivalent to three-month lag deposit. TED spread is basically the difference in yield between 3 month Eurodollar Future and 3 Month T-bill in basis points.
At the peak of the crisis, major banks involved in the issue had their interest rates showing an upward trend, for instance, the period’s component of Morgan’s Interest Rate derivatives drifted from 25.27 Trillion in notional drifted by 7.5 to 32.81 and latter fell to 24.65 Trillion (Brown & Berryl, 2013). It is a valid assumption that such banks were trading to bulge their Interest Rate Derivatives book in the third quarter.
The increase was in their OTC [over the counter] Swap book – that grew by several trillion in the second quarter of the year before falling in the last quarter. So the yield of the trade was OTC Swaps that were for one year, which only stayed on for most of the banks’ books for three months (Grey, 2014).
There is only one tool in the banking industry that fit the phenomena. Forward Rate Agreements (FRA) are mainly OTC Swap tools or simply “bets” between counterparties, over the future position of Libor rates. Buying FRA’s in economic terms refers to “synthetic borrowing” while selling of FRA’s is referred to as “synthetic lending” between the parties. Because FRA’s are “bets” they require that buyer and seller of the product each to have credit lines for one another, because, in the traders never knows which party is going to win the bet.
The natural hedges for U.S. Dollar FRA trades are either Eurodollar futures or U.S. government T-bills, equivalent figures apply for the Euribor. In the third quarter of 2007, the world was gripped by a credit crisis owing to the results of rigging the major players in standardizing the interest rates that they almost lost all their power to lend.
So how did banks like Barclays, Morgan and Rabobank among others manage to achieve trillions of dollars’ worth of FRA’s, which require efficient credit flow when no banks were extending credit. Perhaps a better question is, who were such banks do trillions of FRA’s with when banking counterparties had frozen abilities to extend credit, hence, not trading
The trades could only have been a counterparty
Given that the world was gripped in a credit crisis where no credit was available and given that the likes of Barclays were induced to trade and extend massive amounts of credit and purchase unthinkable amounts of U.S. Government T-bills at ever decreasing yields, a valid conclusion can be made that they were trading with National Treasury itself. The banks executed trillions of dollars’ worth of FRA trades with the U.S. Treasury’s Exchange Stabilization Fund [ESF] for the Libor case.
Rating Agencies are to blame
Any notion that the Libor and Euribor crisis was the fault of currency-centric banks is misinformation and a fabrication (Daniels, 2014). The Libor crisis, for instance, came about when banks, acting prudently stopped buying commercial paper or extending credit – arising from the failure of rated U.S. Mortgage paper.
When the credit markets froze, the U.S. Treasury / Fed panicked and forced rates to go down to almost zero to try to contain the falling market. If the blame for the Libor and Euribor crisis is to be put anywhere, it should be on the rating agencies that rated toxic sub-prime mortgage paper as inappropriately. It was their unexpected conduct, working hand-in-hand with major banks in the respective regions that created the problem.
It is notable that major treasuries, like The U.S. Treasury using the New York Fed as their broker, engaged in a radical therapy for the global credit markets. Major bank implicated in the rigging were fully aware that rates were going to zero and were categorically trading with insider information, they were implementing national monetary policies off their trading desk. This kind of coordination that the capital markets received for years from trusted authorities, for instance, U.S. Monetary Authorities.
Before such manipulations were possible, the forces of people like former Treasury Secretary, Robert Rubin, who pushed for the repeal of Glass-Steagall Act and the supporters of Gramm-Leach-Bliley bill, which repealed the Glass-Steagall Act. Glass-Steagall was a radical tool placed in 1933 to limit the chances that might allow for such financial excesses, the mother of the financial crisis (James, 2013). Repealing the Act removed constraints from the banks since markets were self-regulating. It was financial deregulation, deletion of limits on debt leverage, the total absence of regulation of OTC derivatives and removal of the limits on speculative positions in future markets, that layed the ground for Libor and Euribor problems.
Brown, Y., & Berryl, D. (2013). The rigging Libor and Euribor rates. New York Journal of Economics, 23-30.
Daniels, T. (2014). The credit crisis is based on rigging of rates. Washington: Washington Press.
Fredricks, K., & Emmanuel, H. (2013). What was the source of current credit crisis? Energy Journal, 45-50.
Grey, L. (2014). Analysis of the banking sector. Cincinnati, OH: South-Western University Publishing.
James, A. (2013). The treasury and Libor problem. New York: Spar Press.