Background: LIBOR is the London Interbank Offered Rate. A panel of banks submit their estimated borrowing rates each day. LIBOR is the average of these rates after omitting the two highest and two lowest rates. It is the most commonly used benchmark for interest rates. Countless contracts use LIBOR as their benchmark. Therefore, some banks have an incentive to over or under report the interest rates submitted. For example, suppose Banker’s Trust (BT) borrows $1 billion at a fixed interest rate. BT loans the money to Nigh Eve Investors (NEI) at the variable interest rate of LIBOR plus 1%. At year end, LIBOR is 5% resulting in a present value (fair value) of $1 billion. There is no fair value gain or loss because the interest rates have not changed.[1] Suppose that BT manipulates interest rates so that LIBOR is 5.05 % even though the “real” interest rate is 5%. In this scenario, NEI will pay an additional .05% interest.[2] BT accounts for this transaction as a gain because fair value of the loan was increased.
LIBOR is designed to keep banks from manipulating interest rates. An important procedure is the omission of the two lowest and two highest rates. The example above results in a bank benefiting when LIBOR is high. It is equally common for banks to benefit when LIBOR is low.[3] Therefore, a bank submitting a biased rate is unlikely to affect LIBOR. Banks also have disincentives for submitting biased interest rates.
The rates submitted by each bank are publicly disclosed. If a bank submits interest rates significantly out-of-line with other those of banks, customers and regulators have reason to suspect that bank is attempting to manipulate interest rates. This suspicion can damage the bank's reputation with customers and potentially subject it to regulatory action. Fortunately, there have been few instances in which banks were believed to have manipulated LIBOR.
Case Facts: Bankers in Trust Eternal (BITE) estimate their borrowing rate to be 5.00%. However, other banks are reporting their borrowing rate to be between 5.10% and 5.15%. Why is BITE's actual borrowing rate so much different from the borrowing rates reported by other bankers? One possibility is that other bankers are attempting to manipulate LIBOR. Another possibility is that different banks face significantly different borrowing rates. Neither of these explanations is likely in reasonably stable markets. However, both explanations are credible in the recent financial turmoil. In this time of crisis, some banks were perceived as potential bankruptcy victims, and therefore, had to pay significantly higher interest rates than other banks. For these reasons, the incentives to manipulate LIBOR may have temporarily exceeded the disincentives, but only for banks in crisis. To the extent that these factors had not been fully recognized by regulators and customers, financially sound banks would come under suspicion if they honestly reported their low rates.
BITE’s managers are frustrated because if they report their unbiased estimate of 5.00%, they will appear to be attempting to manipulate LIBOR. They face a difficult decision: should they
be honest and
appear dishonest, or should they
be dishonest and
appear honest?
Requirements: (1) Which parties, if any, will be negatively affected if BITE chooses report 5.10%? Explain. (2) Which parties, if any, will be positively affected if BITE chooses to report 5.10%? Explain. (3) Do your answers above depend on the time frame? In other words, do some parties stand to gain initially but lose in the long run? If so, explain how. (4) What can BITE do, if anything, to ameliorate the deleterious effect of reporting a dishonest number (e.g., 5.10%)? (5) What is the ethical choice and why?
[1] The difference between the 5% borrowing rate and 6% loan rate is not a gain/loss in the current period. For each period, the 6% interest will be revenue (assuming no change in LIBOR) and the 5% interest will be expense. This 1% difference will result in a pre-tax profit over the life of the loans. [2] Assuming ten-year loans in which interest payments are made during the loan and the principal paid at the end of the loans, the current year’s reported gain would be approximately $4 million because the present value of the loan increased by this amount.
Banks often carry about 4% of their assets in equity. At this rate, BT’s equity would be about $40 million. By manipulating interest rates by the seemingly small amount of 0.05%, BT increased their return on equity by 10 percentage points. If BT’s ROE would have been 5% with no manipulation, the manipulation would triple ROE to 15%. [3] In the initial example, suppose that BT’s is borrowing at variable rates and loaning money to NEI at fixed rates. Their incentives would be to manipulate LIBOR downward.