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The Libor scandal is said to be a new high in criminality by bankers. Politicians are gearing up to imprison bankers for cheating. A more careful analysis of the story suggests that while the behaviour of banks was unsavoury, there were mitigating circumstances. Looking into the future, a fresh focus needs to be placed on the informational foundations of finance. Chartered accountants, credit-rating agencies and other data gatherers provide information that can play a vital role in the working of the financial system. Regulators need to be concerned about their conflict of interest and engage in a certain degree of oversight.
Libor is the interest rate at which banks borrow and lend from each other in London. Transactions take place through conversations on the phone. We can know the buying and selling price for shares of Infosys by glancing at the NSE screen. However, there is no comparable screen where we can learn the Libor. For the last 26 years, the British Bankers' Association (BBA) has computed Libor by asking dealers what they saw as prevailing market conditions, deleting the high and low values of the reports, and averaging the rest.
During the global crisis, the inter-bank money market broke down. Banks did not trust each other and stopped lending to each other. No trades were taking place. When bankers were asked to quote a rate, it is reported that they would often delay beyond the usual 11 am because they were in a bind. News reports also suggest that people often gave outlandish numbers and would be asked to reconsider. It was not just Barclays that reported unrealistically low rates, but all of the 160 or more people working in various banks. The US says it had pointed out that Libor rates were too low, and blames the UK regulator for not being alert enough and solving the problem. Four years later, the US is waking up to the fact that a wrong Libor means that many people received more or less money than they should have for contracts linked to the Libor.