By Daniel Archibald | CFA
In April 2015, Deutsche Bank agreed to pay fines of $US2.5 billion for its involvement in "Liborgate". This was a scandal that rocked the financial world and came hot on the heels of the global financial crisis and the Euro debt crisis. Most of the large US and European banks settled with regulators for similarly large sums with UBS agreeing to pay $US1.5 billion, Barclays and Citigroup hit for $US2.3 billion, and JP Morgan forced to pay $US1.9 billion.
What had they done wrong? Simply put, they had manipulated a key financial rate (Libor and other reference rates), used in millions of financial contracts, to benefit their own positions. The main culprit, Libor or London Interbank Offered Rates, are supposed to provide accurate information on the rates at which banks lend and borrow from each other on a number of currencies and over several time periods. Unlike share prices, where market rates are determined by live and public transactions, Libor and other such reference rates were calculated from voluntary disclosure from the world's largest banks. Needless to say, they may have fudged some of the numbers from time to time.
Liborgate opened up the mysterious world of the interbank market to the public eye. This was the world which froze in 2008 (commonly known as the credit crunch), as banks no longer trusted that other banks would be able to meet their obligations. It is a world where 1000s of a percent matter and where banks lend billions for only a night. And as we saw from the GFC and credit crunch, it is vitally important to the way the world works.
Domestic interbank markets are usually cash markets, where local banks trade with each other usually just for one business day. In Australia, the cash market is where banks borrow and lend balances they hold in their Reserve Bank Exchange Settlement Accounts. At close of business on any given day, they may have a surplus because more repayments and deposits came in to the RBA clearing house than loans and withdrawals went out during the past 24 hours. And instead of the surplus simply sitting in their account overnight, bank treasuries will put that surplus to work by lending the funds to a bank that has a deficit for the day. The rate at which they trade at is the overnight rate, which is the rate the RBA targets as the official cash rate.
On a global scale, there is also the interbank foreign exchange market. It is the place where banks go to lend surplus currencies (or borrow deficit currencies) they may have accrued over the course of doing business. It is not a physical market but is a network of over 1000 banks, linked together via brokering platforms and trusted connections.
Following on from the interbank reference rate scandals, central banks and regulators have tightened the way in which key reference rates are set. Despite billions of dollars in fines handed out for rate rigging over the past decade, only a handful of people have been sentenced for criminal offences. New laws and harsher punishments will hopefully act as a deterrent for anyone thinking of fudging the numbers in the future.