Libor: Three Scandals in One

There is a Way to Reduce Rate Fixing

Outside a Barclays branch in London. (Olivia Harris / Courtesy Reuters)

Governments in Europe, Japan, and the United States are now investigating 16 major banks for manipulating interest rates. In the months leading up to the 2008 financial crisis, many of the world's most powerful financial institutions allegedly worked to keep down the London Interbank Offered Rate. Libor, as it is known, is supposed to be the average rate at which the largest and ostensibly safest banks in the world can borrow from one another. Manipulating Libor allowed traders to rig financial markets to their advantage; in the process, they distorted the actual value of key financial instruments such as credit default swaps, derivatives, and home mortgages. 

The scandal has sparked calls from politicians, including Mervyn King, the governor of the Bank of England, for stronger regulation of the world's most powerful banks. But such proposals miss a key point: Price fixing and manipulation are illegal. They have been for a long time. So it is unlikely that saddling financial markets with legal constraints that simply double down on what is already on the books will help. A better solution would go to the heart of the problem. Regulators and market participants should set such benchmark interest rates as Libor in a way that makes them reflect movements in the market, making manipulation impossible.

The fundamental principle underlying floating rates is to allow the market to determine borrowing costs. Customers who borrow on a floating-rate basis, if they are sensible, and institutions that loan money on a floating-rate basis, if they are ethical, therefore expect two things from a benchmark interest rate. First, the benchmark should reflect actual conditions in the financial markets. That means no random fluctuations -- money costs what it is worth. Second, the benchmark rate should not be easy to manipulate. No rational, informed borrower would borrow money at a variable rate of interest and then empower the lender to determine when and how the interest rate changed in the

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