The recent Libor scandal could pose a huge threat to the world economy due to the potential for litigation that could affect multiple markets.
The London Interbank Offered Rate, commonly referred to as Libor, is an interest rate published daily by the British Bankers’ Association that reflects how much banks pay other financial institutions for short-term loans. The rate evolved through the 1970s and is used as the international standard for a number of mortgage and derivatives contracts, The Wall Street Journal reports.
A group of 18 major banks helps establish the rate by sending the BBA an estimated interest rate at which the bank could possibly borrow from other institutions. The BBA eliminates low and high submissions, averaging the remainder in order to establish the daily Libor.
Financial authorities charge that some banks submitted inaccurate rate estimates over the course of several years, which contributed to a distorted Libor. Barclays and other banks being sued by authorities could run into difficulties proving the accuracy of previously submitted rates, as they submitted rates based on a hypothetical situation, according to The Wall Street Journal.
David Malpass, the former deputy assistant Treasury secretary during the Reagan administration and current president of Encima Global LLC, said that this could prove dangerous to the world economy.
“Libor has been a usable benchmark in a volatile system of free-floating exchange rates and interest rates, but by its very nature it is not a precise, market-based price,” Malpass said, The Wall Street Journal reports. “This is not unusual, as financial markets deal with approximations all the time. Unfortunately, if the world now claims that Libor approximations should be exact and then sues over imprecision, the result will be a powerful drag on global growth.”
Additionally, the banks against which the allegations were made could be open to a number of lawsuits. The institutions could have shared information regarding the bank’s submitted Libor rates with other traders in the bank or pushed the bank’s Libor submissions to either the high or low side to influence Libor averages. In both cases, the bank would have profited from nonpublic knowledge, opening the institution to litigation.
Malpass underscored the importance of oversight and problem-solving to prevent another economic slump.
“To reduce the impact of this scandal on global growth, the financial world and their governing bodies need to quickly identify wrongdoing, deal with it and then move forward,” Malpass said, according to The Wall Street Journal. “The world can’t afford endless litigation against the financial system.”