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Martin KenneyManaging Partner at Martin Kenney & Co., Solicitors
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The LIBOR Scandal – Proving Manipulation

August 31, 2012 by Martin Kenney

 A wave of lawsuits have been instituted against a series of banks alleged to have been involved in the rigging of Libor.  One of the earliest of these was instituted as far back as April of this year, by Charles Schwab Short Term Bond Market Fund; Schwab Total Bond Market Fund and Schwab U.S. Dollar Liquid Assets Fund (collectively “the Schwab Funds”).   The Schwab Funds assert claims for violation of federal anti-trust law, RICO and California statutory and common law against no less than 21 Defendants, including the usual suspects, Barclays Bank PLC, the Royal Bank of Scotland PLC and Lloyds Banking Group PLC. 


The crux of the complaint filed originally in the United States District Court for the Northern District of California and then transferred to the United States District Court for the Southern District of New York, and echoed in numerous lawsuits already filed and to be expected in the coming months, is that in setting LIBOR at artificially low rates, the culpable Banks were enabled in paying low interest rates to investors on Libor based financial instruments sold during the period of activity in question. 


The allegations of conspiracy to suppress Libor are based upon a series of what at present can only be described as theories, albeit credible ones.  For example Schwab Funds rely upon the incentive to mask true borrowing costs and reap unjustified revenues; independent analysis carried out by a series of analysts engaged by the Schwab Funds showing a discrepancy between Libor and the Federal Reserve Eurodollar Deposit Rate; and publicly available economic analyses by prominent academics and other commentators.  The complaint also refers to the revelations in connection with the ongoing domestic and foreign governmental investigations into the matter. 


The Schwab Funds’ consulting experts were able to show a discrepancy between the Defendant’s Libor quotes and their respective probabilities of default.  To show this they compared USD-LIBOR panel members’ quotes from 2007 through 2008 to the daily default probability estimates for each of those banks—as determined, and updated daily for each maturity (term), by Kamakura Risk Information Services (“KRIS”).   They used the Kamakura Risk Information Services  or KRIS database to test whether, for the period under study, each bank’s daily sealed LIBOR quote correlates with the bank’s estimated probability of default  that day for the same maturity term. For example, the consultants examined the correlation between Bank of America’s sealed quote for three-month LIBOR on each date with the three-month default probability for Bank of America, as provided by the KRIS database on that same day.   According to standard finance theory there should be a positive correlation between a bank’s default probability and its LIBOR quote, in other words as the bank’s default risk increases, its borrowing rate (LIBOR quote) should increase, and vice versa. The Schwab Funds’ consulting experts found that contrary to the above theory the LIBOR quotes for all the reporting banks (except HSBC) during 2007 were negatively correlated with their daily updated default probabilities (for the same maturity term) to a statistically significant degree. The data indicated that, contrary to fundamental finance theory, the higher a panel bank’s default probability was, the lower its LIBOR quote was.   During 2008 the expert consultants found that for all of the banks, the submitted LIBOR quotes were negatively correlated with their default probabilities at the one-month and three- month maturities.  


It is clear this and other related lawsuits will involve highly technical analysis, it remains to be seen how the Defendant banks will counter the theories advanced, and more importantly how the Judges and juries saddled with the unenviable task of consideration of competing theories will decide which theory is more credible. 


Apart from the plethora of civil law suits, it also appears that the fall out from this scandal will most likely involve criminal charges being brought against individual traders, the investigations by the SEC, the U.K. FSA, the Swiss Competition Commission and regulators in Japan focus not just upon whether banks artificially suppressed LIBOR during the financial crisis, making banks appear more secure than they actually were, but also whether bankers setting LIBOR leaked their data to traders before officially submitting the banks’ LIBOR quotes to the BBA and whether traders at the banks, and at other organizations (such as hedge funds), may have tried to influence LIBOR by making suggestions or demands on the bankers providing LIBOR quotes.  


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