Q&A: Libor rate and the regulators

UBS sign UBS is the latest bank to be hit with fines by international regulators, and others may follow

Swiss banking giant UBS has been hit hard for attempting to rig the inter-bank lending rate Libor.

It is the second major bank to fall foul of the regulators after Barclays was ordered to pay $450m to UK and US authorities in the summer, and others may well follow.

But what exactly is Libor, and why is it so important? Here we take a closer look at the issues involved:

Why do banks lend to each other in the first place?

Banks lend to each other on a short-term basis, either to make a profit or to cover any shortfalls in cash.

For example, a bank may find at the end of a certain day that more customers have made withdrawals than deposits, so it borrows from its rivals to cover the shortfall.

Conversely, banks with a cash surplus can make extra profits by lending funds to a rival. The average rate of interest paid by the banks in such interbank lending is called the London Interbank Offered Rate (Libor).

What exactly is Libor, and how is it calculated?

Libor measures the average rate that banks have to pay to borrow from their rivals for a specific period of time - be it a few weeks, months or up to a year.

It is calculated on a daily basis by the British Bankers' Association from estimates submitted by the major international banks based in London, and represents the interest rate they must pay in order to borrow cash from other banks.

The rate each bank has to pay is in part a reflection of its financial strength, as viewed by its rivals - effectively how much it is trusted.

Every day, 16 banks submit the interest rate that they are charged to borrow money. The four highest rates and the four lowest rates are ignored. The average of the eight remaining rates makes up the Libor rate.

A bank has to pay a higher interest rate to borrow funds if other lending banks have less confidence in it.

This means that the Libor rate gives an indication of the health of the wider banking sector. Libor has a European equivalent called Euribor, which plays the same role for banks based in the eurozone.

Why is Libor so important?

The Financial Services Authority (FSA) says Libor and Euribor are "benchmark reference rates fundamental to the operation of both UK and international financial markets".

The prices of trillions of pounds worth of financial transactions around the world are set according to Libor.

Among them, financial swap deals worth £225tn are indexed to Libor, as are loans totalling about £6.4tn, the British Bankers' Association says.

Libor, and the interest rate swap deals that are based on them, also provide an important indicator of the markets' expectations about the overnight interest rates likely to be set by the world's big central banks - the Bank of England, the US Federal Reserve, the European Central Bank - in the future.

Since the credit crunch first began in 2007, Libor has became an indicator of the financial stress that the major London-based banks found themselves in.

Ironically, the interbank lending market on which Libor is based has actually become far less important because the banks have been much less willing to lend each other money.

Does Libor affect my mortgage?

Some mortgages are directly linked to the Libor rate, although typically this is only the case for very big mortgage borrowers, such as corporations and property developers.

But even for those mortgages that aren't directly linked, Libor still influences the interest rate that banks charge their mortgage or loan customers.

That's because the Libor rate reflects the actual interest rate that the banks have to pay when they borrow money from the markets.

What happened at UBS?

The Swiss bank admitted its staff had rigged its Libor rate submissions for two main purposes.

First, traders manipulated submissions with the express purpose of boosting profits. In fact, according to the FSA, the bank gave traders themselves responsibility for submitting rates to the British Bankers' Association.

UBS also said its traders had colluded with counterparts at other banks, with the FSA saying the bank's Tokyo office had gone as far as paying intermediaries to help rig Libor.

Second, the bank accepted staff had deliberately lowered its submissions during the financial crisis to give the impression it was able to borrow money more cheaply than it actually could. This created the impression that other banks had more confidence in UBS than they did in reality.

The FSA said rigging Libor submissions at UBS was widespread and involved at least 45 people.

What happened at Barclays?

Staff at Barclays filed misleading figures for interbank borrowings they made.

First, between 2005 and 2008 - and sometimes working with traders at other banks - they tried to influence the Libor rate, so as to try to boost their profits.

Then between 2007 and 2009, at the peak of the global banking crisis, Barclays filed artificially low figures. This was to try and hide the level of financial stress under which Barclays was operating.

The bank's chief executive Bob Diamond was forced to resign from his job, along with Barclays chairman Marcus Agius and chief operating officer Jerry del Missier.

What investigations are now underway?

Investigations are continuing across the banking industry, so more evidence is likely to emerge.

The FSA and US regulators, along with counterparts is Canada, Japan in Switzerland, are continuing to look into Libor manipulation. There are at least a dozen other banks being investigated, including Citigroup and RBS.

The Serious Fraud Office is also considering bringing criminal prosecutions in the UK.

Meanwhile, lawsuits have been launched by US municipalities, pension funds and hedge funds.

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