Friday, July 13, 2012

A Fine Line: Some lessons learned from the LIBOR estimate scandal



Recently, the economic and financial media has been awash with talk of a LIBOR scandal.  The London Interbank Offered Rate (LIBOR) is "the most important figure in finance" used to set payments on about $800 trillion worth of financial products (The Economist).  The scandal is that the figure is "rigged" and the process of establishing the LIBOR rate turns out to be a political one where experts work to influence the rate decision.  Emails between key decision makers and producers of the LIBOR estimate reportedly reveal political interests being interjected in the process of determining this most important risk estimate.


The Economist suggest that, in theory, LIBOR is
supposed to be a pretty honest number because it is assumed, for a start, that banks play by the rules and give truthful estimates.
But, there are two things that have become wrong with the process of setting the LIBOR rate and hindered a truthful estimation process.  
First, it is based on banks's estimates, rather than the actual prices at which banks have lent to or borrowed from one another. 
A second problem is that those involved in setting the rates have often had every incentive to lie, since their banks stood to profit or lose money depending on the level at which LIBOR was set each day. 
There are lessons to be learned from this oh, so familiar sounding situation.   


There is no right rate or estimate of risk.  Estimating risk based on something other than observation (eg. a historical average, or actual lending prices) is to give weight to other values, such as profits.  To do this is a decision.  If the decision is to weigh the risk along value preferences, then it is important to acknowledge that the process has become political with potential winners and losers working to influence rate policy.     


Another potential lesson is that there is a fine and non-stationary line between expert judgement and illegal manipulation.  This line ebbs and flows along with the mercy of public perception and trust.  Still not yet recovered from the 2008 loss of trust in the banking and finance industry, the public is quick to perceive bank executives less as insightful experts and more as ruthless money hungry manipulators.  What was once, perhaps, an acceptable practice of using a combination of expert judgment and technical facts now, in a growing number of instances, falls within the realm of illegal activity.  As it becomes increasingly perceived that the LIBOR rates were knowingly estimated for personal gain, banks are facing a potential onslaught of lawsuits akin to the "tobacco movement" of the 1990s.  Perhaps, financial statements will one day come with warnings and graphic images of the Occupy protests =)

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