LIBOR Rate Manipulation

Barclays Bank settles LIBOR manipulation probe.

Source:  St. Louis Federal Reserve Bank

The difference between the LIBOR rate and the OIS rate (Overnight Indexed Swap) represents the default risk of banks as perceived by the market.  That is,  LIBOR is the rate that banks will lend funds to other banks, while the OIS represents a nearly risk free investment.

Historically, this spread has been roughly 10 basis points (1/10 of 1%).  By September 2007 it was 1% – in October 2008 it reached 3.5%.

This suggests the LIBOR rate was severely under reported for many years.  It  permitted banks, such as AIG, to borrow funds at artificially low rates, thereby enhancing profits and transferring risk and losses to counterparties and taxpayers.

Given the extreme volatility of this rate spread, coordination among LIBOR participating banks may have occurred.

US Treasury Secretary Timothy Geithner suggests he learned of the LIBOR anomaly in late 2007 in his capacity as The New York Federal Reserve President.  However, it is not apparent that any action was taken to rectify the situation.

Recently, Barclays Bank agreed to pay $453 million to the US and UK to settle allegations that it manipulated interest rates.  Seven additional banks are currently under investigation.

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