Libor: A Eulogy for the World's Most Important Number -- Update

The world's most important number will be no more.

Libor -- the London interbank offered rate -- was created in 1986 to help banks set interest rates on big corporate loans. Thirty-one years later, a top U.K. banking regulator said the benchmark would be phased out over the next five years.

Libor is calculated by asking banks how much it theoretically would cost them to borrow money from other banks. It wasn't designed to be anything more than an invisible bit of financial wiring, hidden deep below the surface of the banking system. Nobody expected it to become a foundation of global finance -- or a synonym for one of the era's biggest banking scandals.

Libor started out as a symbol of the clubby and arguably incestuous world of London banking in the 1970s and '80s. Libor was based on something resembling an honor system.

Libor quickly came to symbolize much more: the globalization of finance and the adrenaline-crazed, anarchic environment that overtook the banking system in the years leading up to the financial crash last decade.

Banks, driven by a rational desire for ever-growing profits, rushed to create newfangled products that their traders used to place bets on the future direction of interest rates and many other trends -- and Libor became a crucial ingredient. The lobbyist group that ran Libor, the British Bankers' Association, hungered for new revenue sources and concocted dozens of new flavors of its product, across different currencies and time periods.

Meanwhile, American banks adopted Libor to determine what borrowers paid on variable-rate mortgages, student loans and, more recently, credit cards. Libor soon was buried in the fine print of countless contracts all over the world.

Because most derivatives aren't traded on public exchanges, it is hard to say exactly how vast Libor's reach is, but studies have estimated that hundreds of trillions of dollars of financial contracts world-wide are based on the benchmark.

That was great news for the BBA, which triumphantly coined the phrase "the world's most important number." That wasn't much of an exaggeration. The London lobbying group was unregulated, and so was its primary product. A gusher of licensing fees poured into the BBA, which used the funds to push a deregulatory agenda.

But Libor was rife with problems. Its method of calculation -- the BBA simply asked banks to estimate how much it might cost them to borrow -- was inexact at best. And the lack of government supervision proved an invitation for banks to manipulate the number.

Banks had huge stakes in the direction of Libor. The profitability of their loan portfolios hinged on the benchmark's fluctuations. And bank traders, with huge holdings of interest-rate swaps and other derivatives, had billions of dollars riding on tiny swings.

It turned out that banks were skilled at getting Libor to move in favorable directions. After all, it was their employees who were guesstimating their borrowing costs, so it was simple enough to skew those figures in helpful directions.

Tom Hayes, a UBS Group AG and Citigroup Inc. trader who in 2015 was convicted as the ringleader of a Libor-manipulating crew, once estimated that perhaps 5% of his hundreds of millions of dollars in trading profits stemmed from his ability to get Libor nudged up or down by fractions of a percentage point. And he was hardly alone -- dozens of other traders and bank managers were involved in similar manipulative behavior (although Mr. Hayes, sentenced to 11 years in prison, is currently the one of the few behind bars).

When the industry's shenanigans first came to light in 2008, they were greeted by indignant denials from banks, regulators and, most of all, the BBA. But government investigations soon showed not only that manipulation was widespread and easy to pull off, but also that government officials and central bankers had known for years about Libor's vulnerabilities but failed to act.

More than a dozen banks ultimately paid roughly $10 billion in penalties related to their fraudulent Libor activities. Senior executives at banks including Barclays PLC, Royal Bank of Scotland Group PLC and Dutch lender Rabobank Groep NV lost their jobs. The scandal-tarred BBA was recently disbanded.

The era of financial anarchy gave way to a period of intense regulation and risk aversion by banks. Libor -- a potent symbol of the heady precrisis days -- couldn't survive in that new climate.

Central bankers and regulators in the U.S. and U.K. have been reviewing whether it is possible to make Libor safer. Their ultimate conclusion is that the current system is essentially unworkable; there is no way to guarantee the integrity of a benchmark that is based purely on guesswork by banks, especially when those banks have powerful interests in the outcome of their guesswork.

"It is not only potentially unsustainable, but also undesirable, for market participants to rely indefinitely on reference rates [like Libor] that do not have active underlying markets to support them," Andrew Bailey, the head of the U.K.'s Financial Conduct Authority, said in a speech Thursday. He cited Libor's susceptibility both to manipulation and to malfunctioning in a crisis.

The goal now is to find or create comparable benchmarks that are calculated based on actual transactions in the market -- in other words, derived from actual, not theoretical, borrowing costs. The new measurements are likely to lean on algorithms, a reflection of the increasingly computerized and robotic nature of the financial system.

Five years from now, Libor isn't likely to exist. Its legacy -- distrust in banks and doubts about regulators' ability to police the industry -- is likely to linger.

David Enrich is author of "The Spider Network: The Wild Story of a Math Genius, a Gang of Backstabbing Bankers, and One of the Greatest Scams in Financial History," a book about the Libor scandal. You can write to him at

david.enrich@wsj.com

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(END) Dow Jones Newswires

July 27, 2017 16:48 ET (20:48 GMT)