By Robert Tammero, Craig and Macauley Professional Corporation
On Thursday, March 21, 2013 Professor David Scharfstein of the Harvard Business School delivered a presentation at the Boston Bar Association about Libor – the London Interbank Offered Rate.
Professor Scharfstein’s presentation began with an overview of what Libor is and how it is set. Professor Scharfstein explained that Libor is a set of reference rates published daily by Thompson Reuters for 10 currencies and 15 maturities (from overnight to 12 months). The rate is set by the British Bankers’ Association by calculating a trimmed average of the responses of a panel of major banks to the question “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11:00 a.m. (London time)?” Libor is therefore meant to represent the average cost of funds of a sample of major banks in various currencies at various maturities.
Professor Scharfstein summarized the major applications of Libor in financial and commercial markets. Libor, he explained, is often used as the base rate in syndicated loans, floating rate corporate debt instruments, and derivatives such as forward contracts, interest rate swaps, and Eurodollar futures. In a typical Libor-based interest rate swap, for example, one party agrees to make periodic fixed interest rate payments to a counterparty in exchange for the counterparty making periodic variable interest rate payments to the first party at Libor plus some percentage. The parties may be obligated to make payments to each other in the same or different currencies. Each party’s interest payments are based on a notional principal amount specified in the swap contract.
Professor Scharfstein then described how Libor is alleged to have been manipulated by certain major banks during the recent global financial crisis. Professor Scharfstein explained that one class of Libor manipulation claims alleges that during the crisis, certain banks intentionally reported lower-than-accurate Libor-setting rates to make the bank appear financially stronger than it in fact was. A second class of Libor manipulation claims alleges that certain banks intentionally misreported Libor-setting rates to cause particular trading positions to be profitable for the reporting bank. Professor Scharfstein presented excerpted internal communications between traders and the Libor desks of certain banks suggesting that these parties engaged in Libor manipulation. Interviews of some of those alleged to have been involved in Libor manipulation during the recent financial crisis indicate that Libor manipulation has occurred for many years.
Professor Scharfstein closed by briefly discussing ideas to reform the process by which Libor is set. These ideas include subjecting the process to oversight by a body charged with maintaining Libor’s integrity, setting Libor based on market data from actual interbank transactions, and replacing Libor entirely, for example, with a set of rates based on U.S. Treasury securities. Professor Scharfstein indicated that significant reform to Libor faces major hurdles due to Libor’s global pervasiveness in financial and commercial markets and the lack of a viable alternative.
 Lower reported Libor-setting rates imply lesser credit risk in lending to the reporting bank.