Interest rates all over the world are mostly made up.

That's the verdict of a new study by the International Organization of Securities Commissions, a copy of which was obtained by Bloomberg. It found that more than half of the benchmark lending rates in the U.S., Europe and Asia are "calculated by methodologies that were unclear, not transparent and only rarely subject to specific regulatory standards or obligations." Less than half of all benchmark lending rates, in contrast, were based on actual market transactions.

In other words, the interest rates that affect personal and business loans, and hundreds of trillions of dollars in derivatives contracts around the world, are based on either guesses or lies: Not particularly comforting.

“The risk of manipulation will be greater where participants in the process have both incentive and opportunity to submit inaccurate data or apply a methodology inaccurately,” IOSCO wrote, according to Bloomberg. “Furthermore, where judgment is required in determining the data to be submitted, the problem is particularly acute.”

English translation: When banks can just make up these benchmark numbers, they're likely to cheat. Even when they can't just totally make up the numbers, they still try to find ways to cheat.

Recently the world has been focused on the rampant manipulation of one such interest rate, the London Interbank Offered Rate, or LIBOR. Barclays Capital has already paid $460 million in fines in that scandal, and more than a dozen other banks are under investigation, including JPMorgan Chase, Bank of America and Citigroup. Meanwhile, lawsuits and potential legal costs to the banks are piling up.

LIBOR is used in all sorts of financial transactions, from setting your adjustable-rate mortgage to interest-rate swaps bought by state and local governments to hedge against a jump in borrowing costs. LIBOR is supposed to be based on what a group of banks say is their daily cost of borrowing money from other banks for short periods of time.

The trouble is, these borrowing costs are self-reported, and it is pretty easy for the reporting banks to manipulate the rates if they want to. Sure enough, they have often wanted to, either to make their borrowing costs look lower than reality, or to gain a small advantage in derivatives trades, or both.

And, as it turns out, most other benchmarks around the world have the same problem, according to the IOSCO study.

After barely caring about LIBOR manipulation for many years, regulators are now trying to figure out how to fix LIBOR and other benchmark rates. A Bloomberg poll earlier this month found that investors expect the current LIBOR system to be overhauled within the next five years.

An overhaul will be tricky. There aren't always market transactions available to set interest rates; there's almost always going to be some need for estimates and human judgment in setting these rates, which means there might always be room for error or manipulation. Some in the market argue that short-term interest rates are being manipulated by central banks anyway, so there's not much harm in banks doing the same thing. And that's not always necessarily wrong.

The problem, though, is that nobody trusts the reality of LIBOR and similar benchmarks anymore, and it is unhealthy to have an untrustworthy financial system for very long.

“The Libor scandal should not be something to be hidden under the carpet because it affects the correct functioning of financial markets and the economy as a whole,” Mario Cribari, head of asset management at Veco Invest SA in Lugano, Switzerland, told Bloomberg earlier this month.

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  • BARCLAYS

    The UK bank has been at the centre of a very public storm since U.S. and British authorities fined it more than $450 million last month for its part in manipulating Libor. The ensuing backlash cost chief executive Bob Diamond and chairman Marcus Agius their jobs. The pair have appeared before a parliamentary committee to testify about what went on at the bank, in a scandal which has drawn in British central bankers and government ministers.

  • BANK OF AMERICA

    Bank of America is among the banks being investigated, a person familiar with the matter told Reuters last year. The bank did not comment in its 2011 annual report. It is one of 11 banks accused of conspiring to manipulate Libor in two lawsuits filed by discount brokerage and money manager Charles Schwab.

  • BTMU

    The Swiss Competition Commission said in February that Bank of Tokyo-Mitsubishi UFJ was among those it was investigating on suspicion of conspiring to manipulate rates. The Japanese bank did not comment on any probes in its 2011 annual report. This month, the group suspended two London-based traders as a result of a probe into manipulating interbank lending rates, but the bank said that was not to do with their conduct at BTMU. They had previously worked at Dutch lender Rabobank.

  • CITI

    Citigroup said its subsidiaries had received requests for information and documents as part of investigations in various jurisdictions. The U.S. bank said it was cooperating. The bank is also subject to a number of private lawsuits filed in the U.S. against banks that served on the Libor panel. In December, Japan's financial regulator said it would penalise the Japan securities units of Citigroup and UBS after finding that an individual who worked at UBS and then moved to Citi had, along with his boss at Citi, attempted to influence the Tokyo interbank offered rate (Tibor).

  • CREDIT SUISSE

    Credit Suisse is one of 12 banks being investigated by the Swiss Competition Commission about alleged collusive behaviour among traders to influence the bid ask spread for derivatives tied to Libor and Tibor as well as the rates themselves. Credit Suisse said it was cooperating fully.

  • DEUTSCHE BANK

    The German bank said it was cooperating with investigations in the United States and Europe in connection with setting rates between 2005 and 2011. It has had civil actions filed against it in the United States related to the setting of Libor. Germany's market regulator has launched a probe into the bank over suspected manipulation of interbank lending rates, sources have said. Results are expected in mid-July. German magazine Der Spiegel reported, citing no sources, that two Deutsche Bank employees have been suspended after external auditors examined whether staff were involved in manipulating rates.

  • LLOYDS

    Lloyds said it was cooperating with investigations. It has also been named in private lawsuits in the U.S. related to the setting of Libor. It said it 2011 annual report that it could not predict the ultimate outcome of investigations or lawsuits. In May, the bank said two derivatives traders had been suspended following an investigation into possible interest rate manipulation.

  • HSBC

    HSBC has said it received demands from regulators for information in connection with Libor investigations and it was cooperating. It has also been named in lawsuits related to Libor in the United States. HSBC said in its 2011 annual report that it could not predict the outcome of the investigations and lawsuits.

  • HBOS

    The bank, now a subsidiary of Lloyds, said it was cooperating with investigations. It has also been named in private U.S. lawsuits related to the setting of Libor. HBOS said it in its 2011 annual report it was not possible to predict the scope, outcome or impact of the investigations and lawsuits.

  • JPMORGAN

    JPMorgan said it was cooperating with regulators and government bodies investigating the setting of Libor, Euribor and Tibor rates, mainly in 2007 and 2008. It has also been named as a defendant in private U.S. lawsuits over Libor.

  • RABOBANK

    Rabobank said it was cooperating with investigations into possible manipulation of Libor rates. It has also been named as a defendant in a number of civil lawsuits in the United States. Rabobank said it was confident the claims would be held unfounded and was conducting its defence as such.

  • RBC

    Canada's largest bank did not make any comment in its 2011 annual report on its involvement in regulatory probes into possible manipulation of interbank lending rates.

  • RBS

    Royal Bank of Scotland said it was cooperating with investigators, who had requested information. RBS said members of its group had been named as defendants in a number of lawsuits in the United States. The bank said it had substantial defences to these claims. Following a newspaper report last month that it faced a 150 million pound fine, RBS said there could not be any certainty as to the timing or amount of any fine or settlement.

  • UBS

    The Swiss bank said it had been granted leniency or immunity from potential violations by some authorities, including the U.S. Justice Department and Swiss Competition Commission, in return for its cooperation in the Libor manipulation probe. It did not specify what information it was providing. In December, Japan's financial regulator said it would penalise the Japan securities units of Citigroup and UBS after finding that an individual who worked at UBS and then moved to Citi had attempted to influence Tibor. It has also been the subject of U.S. lawsuits.

  • WEST LB

    The German bank was among those being investigated, a person familiar with the matter told Reuters in March last year. The bank made no mention of the probes in its 2011 annual report. In July last year it was dropped, at its request, from the panel of banks contributing to daily fixings of Libor for U.S. dollars.

  • NORINCHUCKIN

    The Japanese bank did not mention the investigations into possible Libor manipulation in its 2011 annual report. In April last year it was one of 12 banks sued by Vienna-based asset manager FTC Capital, accused of conspiring to manipulate Libor.

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