In 1984, the British Bankers Association, with the assent of the Bank of England, decided to collectively fix interest rates, to facilitate trading the new financial instruments which bankers were dreaming up. The London Interbank Offered Rate (Libor) became an international standard, with rates set by a committee of 18 global banks. Using an averaging process that throws out the high and lows, Libor rates are set by banks based upon what they think they would have to pay to borrow if they needed money.
You have this vast array of financial instruments that hang their own fixes off a rate that doesn’t actually exist. ~ former Libor trader
In theory, Libor is supposed to be an honest number, because, it was assumed, that banks play by the rules and give truthful estimates. In reality, the system is rotten.
1st, Libor rates are set based on bank estimates, rather than the actual prices at which banks have lent to or borrowed from one another.
2nd, banks have every incentive to lie, as they stand to profit or lose depending on the Libor rates set each day. Worse still, the transparency in the mechanism of setting rates exacerbates the propensity to lie rather than suppressing it. Weak banks do not want to signal their dilemma with an honest estimate of the high price they would have to pay to borrow, if they could borrow at all.
Unsurprisingly, Libor rates were rigged via collusion shortly after the system was set up. To keep the lending wheels greased, rates were generally set lower than market rates would have been.
Going back to the late 1980s, when I was a trader, you saw some pretty odd fixings. With traders, if you don’t actually nail it down, they’ll steal it. ~ another former Libor trader
It was one of those well-kept secrets, but the regulator was asleep. The Bank of England didn’t care, and the participating banks were happy with the reference prices. ~ yet another former Libor trader
Libor rates became embedded in the world banking system as key references and remain so today.
As the global financial crisis begin in the middle of 2007, credit markets started to freeze up. The unexploded bombs littering the banking system had banks not trusting one another; yet Libor rates remained suspiciously low given the environment.
Government regulators in the UK and US were tipped off to Libor rigging in 2008, but with the financial fiasco full-blown, nothing was done until 2012, when the banks that managed to survive their self-created maelstrom were slapped on the wrist with fines. The culprits included all international banks in the Western world. As usual, only bank minions faced lackluster criminal prosecution, with few convictions.
The scandal mortally wounded Libor, though it took years to bleed out and die. From the mid-2110s, Libor was phased out for similar benchmarks, most notably SOFR, which is a measure of the cost of US banks borrowing cash overnight. (SOFR = Secured Overnight Financing Rate, compiled by the US Federal Reserve.)
Interest rates price debt via regulated mechanics. In contrast, the prices of equities are determined with all the decorum of a barroom brawl.