The media have a tendency to oversell every story about the evils of banking as "the most important." Hyperbole is easy and fun and eye-catching. But it's also dangerous. It clouds reason and gives commentators easy ways to avoid discussing issues that underpin events. The LIBOR scandal offers a perfect example of how hyperbole has dulled us to what actually is the biggest news story in finance since the crisis and a situation that will affect the financial markets for years to come.
What we know so far
The problem, as far as I can tell, is that Barclays (NYSE: BCS ) is a British bank, so no one seems to care. But people will care. Already, we know that Bank of America (NYSE: BAC ) , JPMorgan (NYSE: JPM ) , and Citigroup (NYSE: C ) are under some sort of scrutiny in the U.S. In the U.K., the net includes pretty much every bank you've never heard of.
Barclays was the first out of the chute, and so the vast majority of press has centered on its involvement. The bank has agreed to a set of fines totaling $450 million for deliberately trying to change the LIBOR rate. The investigation focused on a series of email chains between investors at the bank and the bank's internal rate setters. The emails spanned 2005 to 2009 and include all sorts of juicy sound bites about champagne and funny pet names.
The investigation's findings show two important reasons Barclays fiddled with LIBOR. The most straightforward was to make money on trades. Barclays could make trades that hinged on LIBOR, like an interest rate swap. In order to increase the payoff for the bank or its customers, the investors would ask to have the rates manipulated in their favor. Boom, free money.
The second reason to manipulate rates is the more disturbing reason. It's more disturbing because it's the kind of thing that gave every bank that submitted to LIBOR, regardless of investments, a reason to play around. The other reason that Barclays submitted artificial rates was to appear stronger when compared to its peers.
The big game
LIBOR works like this. The British Bankers Association has these two guys, let's call them Chuck and Jimmy. Chuck and Jimmy sit in a room in London, and every day around 11 a.m., they get submissions from big banks. The two sit down, plug the numbers into a basic equation that trims the outliers, and out comes that day's rate. Voila!
The interesting thing is what the submissions represent. Banks don't just submit the rates at which they lend or borrow money. They submit the rate at which they think they should be able to borrow money on that day. The "think" in that previous sentence is what makes the system so dangerous.
Barclays, and all other submitting banks, should publish a rate that reflects how difficult it is for it to borrow money. If it's in a bad way, then the rate should go up. But what Barclays did in 2008 was to submit lower rates to make it seem stronger. It's like wearing an Olympic medal you didn't earn; it doesn't make you a good diver, but it makes other people think that you're a good diver.
Since you're just submitting a sort of theoretical rate, Chuck and Jimmy don't have a way to check to see if you're lying. Barclays got caught because it wrote down that it was lying.
So far, there is no public evidence of any other banks manipulating their submissions. But Barclays has intimated that more heads will roll, saying that it is merely "the first to reach resolution of these issues." But it seems that not every bank is being painted with exactly the same brush. Global giant HSBC (NYSE: HBC ) has been given a clean bill of health by the U.K.'s Financial Services Authority. Likewise, none of the French banks involved in LIBOR have been implicated.
While most banks are keeping quiet, upcoming quarterly filings could be telling. Barclays' Q1 filing increased operating expenses by $115 million for legal provisions, although with no explanation of exactly why. Investors in American banks will want to keep an eye on these sorts of expenses, as well.
The bottom line
The best advice I can give for now is to ignore the yelling about evil bankers, and the general fall of civilization. No one knows yet how big this scandal is, or what the implications will be for the long term. The sound bites are surface material only. The real issue isn't whether some bankers are jerks. It's what the manipulation of the LIBOR means. In an even bigger context, it's about whether a system like LIBOR even makes sense.
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