The more we learn about the manipulation of the London interbank offered rate, the more expensive the scandal becomes for the financial institutions involved. If banks want to control the damage, they would do well to come clean sooner rather than later about the full extent and effect of their misbehavior.

Recent revelations about misdeeds at Barclays Plc, Royal Bank of Scotland Group Plc and UBS AG -- only three of more than a dozen banks under investigation -- are enough to keep lawyers and courts busy for years. In thousands of incidents throughout much of the 2000s, traders sought to manipulate Libor and other benchmark interest rates that influenced the value of hundreds of trillions of dollars in loans, bonds and derivatives. Judging from the traders’ communications, they often succeeded and profited handsomely. What’s more, the culture of deception was sometimes institutional. During the 2008 financial crisis, banks misrepresented their borrowing costs to make themselves look healthier than they were -- behavior that would have skewed payments on Libor-linked financial contracts worldwide.

While we can expect government settlements with the banks to be costly, it’s safe to assume that the ensuing civil litigation will be more expensive still. If, for example, payments on $300 trillion in financial contracts were off by only 0.1 percentage point for a year, plaintiffs could potentially demand compensation for $300 billion in losses. That’s the equivalent of more than four years’ net income for the 16 banks involved in setting Libor in 2008.

Triple Damages

As Bloomberg Markets reports in its latest issue, the lawsuits are piling up. At least 30 cases are pending in federal court in New York, many claiming triple damages under antitrust and other statutes. In London, lawyers are suggesting that the level of manipulation was so great that contracts tied to Libor should be considered null and void, forcing banks to return any related payments. Such a “nuclear option” could severely damage the legal foundation required for the broader financial markets to function.

How bad it gets depends largely on the banks. Intransigence and obfuscation would serve mainly to delay the reckoning and increase everyone’s legal bills. Alternatively, the banks could try to head off the litigation before it gets out of hand, taking an approach similar to that of oil giant BP Plc after the 2010 Deepwater Horizon disaster. This would entail releasing all available information on the banks’ actual borrowing transactions and making a best-possible estimate of how much Libor was off. It would also require all the banks involved to contribute to a joint fund and set up a mechanism to compensate victims willing to settle out of court.

Deutsche Bank AG co-Chief Executive Anshu Jain said Jan. 31 that CEOs of the institutions involved in the Libor scandal had discussed the possibility of a global settlement at the World Economic Forum in Davos. Although it wasn’t clear exactly what he had in mind, the talks suggest that the banks are capable of the necessary level of coordination.

A well-executed compensation fund would have the added advantage of demonstrating that the banks want to make a clean break with the sordid past and that they care how their behavior affects their customers. The question, then, is whether they really do.

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