Posted on 31st Jul 2012 @ 11:58 AM

This was a banner week for bank-bashing, thanks to Barclays’ LIBOR party, the potential increase in JPMorgan’s “insignificant” loss to $8 or 9 billion, and various overdraft settlements [described below].

Several top managers at Barclays resigned amidst charges of LIBOR manipulation. What’s the big deal? Well, imagine that X contracts with Y, agreeing that X will pay Y $1 million if Y’s home burns down. Y burns the house and demands a million bucks. This example is a bit extreme, yet many contracts worldwide (including corporate loans, adjustable rate mortgages, college loans, interest rate swaps and other derivatives) are tied to various LIBOR (London Interbank Offered Rate) indices. The manipulation of LIBOR rates, intended to represent the lowest real-world cost of unsecured funding in the London market, would have global ramifications.

Big banks own large positions in these contracts. Some of the banks are the same 16 (more or less) institutions canvassed daily for the purpose of determining those very indices. For a set of maturities and currencies, they respond to this 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 a.m.?” The compiler (Reuters, on behalf of the British Bankers Association) “trims” the submissions, generally ranking the 16 rates from highest to lowest, dropping the highest and lowest 4, then averaging the remaining 8 rates.

A bank can fudge its responses to this admittedly hypothetical question, toward the goal of gaining millions on its existing contracts. While a particular bank’s influence may be diluted by Reuters’ trimming, the possibility exists that the banks might collude to fix their inputs.

Does the LIBOR fiasco affect smaller banks? Yes, it does, even if they aren’t involved in LIBOR-related deals. This kind of shady behavior taints public opinion. It may prompt legislators or regulators to prohibit consumer products tied to indices within a bank’s control (such as Regulation Z’s restrictions on indices used for home-equity lines of credit). It may motivate Congress to adopt legislation, such as Dodd-Frank, to expand or reinforce the reach of an agency’s authority to ban unfair, deceptive or abusive acts and practices (UDAAP). It puts into doubt the legitimacy of the LIBOR indices to which some consumer mortgage rates are pegged. If manipulated LIBOR values are lower than they should be, LIBOR ARM customers will pay less interest than they should.

Community banks, tarnished again by the actions of their “more sophisticated” brethren, must find ways to distinguish their segment of the business. Just because a smaller bank looks like a bank, walks like a bank, and talks like a bank, doesn’t mean it’s a big bank.

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