The LIBOR Scandal for Dummies

Photo (cc) by _dChris

When you see criminals like Bernie Madoff doing a televised perp-walk, two thoughts probably come to mind. The first is “What was he thinking?” The next, “I’m sure glad that didn’t happen to me.”

In recent weeks, a scandal has been unfolding that could potentially make the Wall Street Bernie look like Sesame Street Bernie. And yet, despite the trillions of dollars involved, the sheer audacity of the fraud, and the irony of so many leaders clamoring for less bank regulation – Mitt Romney, along with many in Congress, have called for repeal of the Dodd–Frank Wall Street Reform and Consumer Protection Act – there hasn’t been much in the mainstream media about LIBOR.

Other than the name, the LIBOR scandal isn’t all that complicated. In the video below, I ask a finance professor to explain it in simple language. Check it out, then meet me on the other side for more…

How LIBOR works

You probably don’t think much about where interest rates come from. On everything from credit cards to savings accounts, you’re presented with a rate, then you simply decide whether to take it or not. Whether you’re borrowing or investing, you logically assume the rates you pay or earn are set by competition.

But as you learned in the video above, interest rates on trillions of dollars worth of financial products start with a benchmark called the London Interbank Offered Rate, or LIBOR.

While the label makes it sound complicated, it’s just the average interest rate big banks pay to borrow from each other. It’s called “London” because it’s computed in that city. But that’s misleading, because it affects interest rates worldwide on some (but not all) adjustable-rate mortgages, credit cards, and student, car, and other types of loans. In addition to loans, it’s also used to set rates for institutional investments – the kind that mutual funds, pension funds, and government agencies might use to earn interest on short-term investments.

What’s the problem?

LIBOR isn’t set by supply and demand. It’s not set by the market or the government. Instead, it depends on the banks involved (including giants like Citigroup, JP Morgan Chase, Bank of America, and Barclays) to accurately report the interest rates they’d have to pay to borrow from each other. The highest and lowest rates are thrown out, the rest are averaged, and LIBOR is set.

So LIBOR depends on honesty. If banks don’t tell the truth, LIBOR won’t be accurate – nor will the interest rates on trillions of dollars worth of loans and investments.

Why would they lie?

Banks would lie about the rates they’d pay to borrow for two reasons.

The first is to make themselves seem stronger than they are. As with you and me, if a bank is a good risk, they’ll pay less interest. So if a bank reports that the rate it pays to borrow from other banks is low, the financial world will think they’re strong.

The other reason a bank may want to lie about what it costs them to borrow is to make money. Major international banks do more than lend. They also trade stocks, bonds, and all kinds of other investments for the same reason any investor does: to make a profit.

Traders working for banks participating in LIBOR could simply buy an investment that goes up when rates fall, then lie about their rates in an attempt to lower LIBOR. In short, they could manipulate the market and position their investments to make money, essentially trading on inside information. This is especially true if banks magnified the impact of their reporting by colluding with one another.

How does it affect me?

If LIBOR was manipulated, the results could be far-reaching. Since LIBOR is the benchmark for many other rates, an inaccurate LIBOR means millions of people all over the globe might have paid more or less interest than they should have. If rates were artificially low, borrowers for things like adjustable-rate mortgages and student loans would have benefited. But investors like cities, mutual funds, and pension plans may have earned less than they should have.

The extent and impact of LIBOR manipulations is still unknown. The effect on the average consumer is probably small, but as the professor in the video above opined, it could be measurable to people with large loans tied to LIBOR, like those with adjustable-rate mortgages.

What’s happened so far?

In late June, Barclays Bank agreed to pay $450 million to settle accusations it had lied in an attempt to manipulate LIBOR to make money and present itself as healthier than it was. Other banks participating in LIBOR are now under investigation, with many experts now predicting more banks will be writing similar checks in the days ahead.

What should I do?

First and foremost, be mad.

Be mad that you’re expected to play by the rules in a system where the biggest players don’t. Be mad at regulators that didn’t properly regulate. Be mad that making billions in profits isn’t enough for some financial institutions: they have to game the system to make even more.

And be suspicious when you hear someone insisting banks are over-regulated.

Disclosure: The information you read here is always objective. However, we sometimes receive compensation when you click links within our stories.

Read Next
25 Things You Should Never Buy — and What to Buy Instead
25 Things You Should Never Buy — and What to Buy Instead

If you really want to save money, become a more intentional shopper.

Why Is My Pension Killing My Social Security Benefit?
Why Is My Pension Killing My Social Security Benefit?

A reader says the government is penalizing him for having a pension. Is he right?

16 Affordable Products That Could Save Your Life
16 Affordable Products That Could Save Your Life

You’ll want to order these sometimes surprising products from Amazon ASAP.

5 Countries Where You Can Retire on $2,000 a Month or Less
5 Countries Where You Can Retire on $2,000 a Month or Less

These tips on retiring overseas come from someone who’s been helping American expats for decades.

7 Mistakes Guaranteed to Ruin Your Retirement
7 Mistakes Guaranteed to Ruin Your Retirement

Make even one of these money mistakes, and you’ll probably end up eating ramen noodles in your golden years.

View this page without ads

Help us produce more money-saving articles and videos by subscribing to a membership.

Get Started

Most Popular
7 Kirkland Signature Items to Avoid at Costco
7 Kirkland Signature Items to Avoid at Costco

Even if it seems you save a bundle buying Costco’s Kirkland Signature brand products, they may not be the bargain they appear to be.

How to Buy Gas At Costco Without a Membership
How to Buy Gas At Costco Without a Membership

The warehouse club often has some of the cheapest gas in town. Here’s how you can get it as a nonmember.

10 Things to Stop Buying If You Want a Clutter-Free Home
10 Things to Stop Buying If You Want a Clutter-Free Home

If you like to keep things simple, avoid these purchases.

If You Find This Thrift Shopping, Buy It
If You Find This Thrift Shopping, Buy It

Vacuums from this brand can last a half-century, if not longer — and they’re hot on the resale market.

A Simple Way to Silence Robocalls Today
A Simple Way to Silence Robocalls Today

A few steps can keep your phone from ringing when a spammer calls.

This Company Makes the Best Tires in America
This Company Makes the Best Tires in America

Driver satisfaction with tires is at an all-time high, but one brand stands out.

This Health Issue Can Hint at Dementia Years in Advance
This Health Issue Can Hint at Dementia Years in Advance

One type of pain is especially associated with cognitive decline.

Can I Switch to Spousal Social Security Benefits When My Ex Dies?
Can I Switch to Spousal Social Security Benefits When My Ex Dies?

Knowing when to claim can help you maximize benefits.

36 Things That Will Be Obsolete Soon
36 Things That Will Be Obsolete Soon

The writing is on the wall for dozens of things we have grown up with.

Medicare Will Not Cover These 6 Medical Costs
Medicare Will Not Cover These 6 Medical Costs

Don’t let these health care expenses catch you off guard in retirement.

8 Things You Should Always Buy on Amazon
8 Things You Should Always Buy on Amazon

The giant retailer shines when it comes to these things, from basics to hard-to-find specialty goods.

5 Ways to Get Amazon Prime for Free
5 Ways to Get Amazon Prime for Free

Hesitant to drop $119 a year on an Amazon Prime membership? Here’s how to get it for free.

8 Federal Income Tax Breaks for Homeowners
8 Federal Income Tax Breaks for Homeowners

Some of these deductions and credits are available to a wide swath of homeowners.

5 Ways to Fill Your Pantry With Free Food
5 Ways to Fill Your Pantry With Free Food

Anyone can take advantage of these resources.

3 Ways to Get Microsoft Office for Free
3 Ways to Get Microsoft Office for Free

With a little ingenuity, you can cut Office costs to zero.

10 Types of Retirement Income That Are Not Taxable
10 Types of Retirement Income That Are Not Taxable

There are lots of things Uncle Sam can’t touch — so long as you play by the rules.

6 Reasons You Should Stop Hiding Cash at Home
6 Reasons You Should Stop Hiding Cash at Home

Stashing money around the house is anything but harmless.

5 States With the Worst Health Care for Retirees
5 States With the Worst Health Care for Retirees

All of these states are located in the same region of the nation.

5 Products You Should Never Buy Generic
5 Products You Should Never Buy Generic

Sometimes the brand-name version is clearly superior.

View More Articles

View this page without ads

Help us produce more money-saving articles and videos by subscribing to a membership.

Get Started

Add a Comment

Our Policy: We welcome relevant and respectful comments in order to foster healthy and informative discussions. All other comments may be removed. Comments with links are automatically held for moderation.