Illustration by Bloomberg View
Illustration by Bloomberg View

The scandal over the manipulation of Libor has the potential to become one of the most costly and consequential in the history of banking. If the financial institutions involved want to prevent it from overwhelming their businesses and damaging the broader economy, they’ll have to act fast.

Investigators in the U.S., Canada, Europe and Asia are piecing together a breathtaking portrait of avarice and deceit. To hide their institutions’ problems during the financial crisis, or often to boost their traders’ profits, bankers knowingly submitted false data for the calculation of the London Interbank Offered Rate, a benchmark interest rate that influences the value of hundreds of trillions of dollars in financial contracts around the world, including floating-rate mortgages, corporate loans and interest-rate swaps.

The roughly $450 million in fines paid by Barclays Plc, the first bank to fess up, is only the beginning. Regulators can and should hit more banks with large fines to prevent a repeat. More important, criminal charges for the first time could threaten a significant number of bankers and traders with jail terms for their actions during the financial crisis -- a much needed comeuppance that could help reset the industry’s moral compass.

It is the lawsuits, though, that have the potential to turn a necessary catharsis into a systemic disaster. Plaintiffs ranging from investment firms to municipal governments, many of which bought bonds or entered into contracts that provided payments tied to Libor, are demanding compensation from banks for intentionally pushing down the benchmark. Attempts by traders to rig Libor on specific days, portrayed in detail in the Barclays case, will undoubtedly elicit more legal actions.

Estimates of payments related to lawsuits are currently in the billions or tens of billions of dollars. The full scope of possible litigation, though, won’t be known until the details of civil and criminal investigations emerge.

To get a sense of magnitude, consider this: If Libor was understated by an average of only 0.1 percentage point for a year, the discrepancy on the roughly $300 trillion in interest-rate swaps outstanding at the time would add up to $300 billion. That’s about a fifth of the aggregate capital of the 16 banks whose reports were used to calculate Libor in 2008. Much of that amount would not be actionable, but it also doesn’t account for other types of financial contracts or potential punitive damages.

It’s in no one’s interest if the prospect of decades of litigation, and prolonged uncertainty about the ultimate cost, cripples the banking system. It’s certainly the last thing a struggling global economy needs. Bank executives, regulators and prosecutors should be thinking now about how to come clean quickly, compensate the victims and move on.

The fund set up by BP Plc to pay claims related to the 2010 Deepwater Horizon oil spill offers one possible template. Banks could pool their resources into a global Libor victims’ compensation fund, appoint an independent administrator and create a transparent formula to calculate damages. Doing so might persuade angry clients to settle rather than pursue litigation that would serve mainly to enrich armies of lawyers.

Such a move would require a lot of cooperation and candor among the banks. For one, they would have to come up with an authoritative estimate of how much Libor was skewed as a result of their misreporting. Beyond that, they would have to decide what share of the payments each bank should bear. One bank -- Barclays is a prime candidate -- might have to take the lead in setting up the fund, as BP did after the oil spill, and press the others to pay their share later.

Governments can expedite the process. By quickly bringing and settling criminal charges against the financial institutions (as opposed to charges against the individuals who worked in those institutions), they would remove one obstacle preventing banks from admitting wrongdoing.

The Libor scandal offers a sad illustration of the moral bankruptcy that has infected some corners of finance. If the response fails to demonstrate a clear break from the past, the repercussions could again inflict a lot of pain on millions of innocent people. This time, the financial sector has little goodwill to spare.

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Today’s highlights: the editors on Hillary Clinton’s visit to Egypt; Jonathan Alter on Republicans’ stop-the-vote plan in Pennsylvania; Stephen L. Carter on our national Lincoln obsession; William Pesek on North Korea’s opening to the West; Jonathan Weil on the Barclays Libor scandal; John H. Cochrane on fixing health care; Frederic Block on how he sentences federal criminals.

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