If you’ve been following the Westpac and ANZ scandals of recent weeks, you will have heard the term ‘bank bill swap rate’ bandied about in the media.

And if you’re one of the millions of Australians who have secretly wondered, ‘What on earth does that mean?’, then this article is for you.

The bank bill swap (BBSW) rate is the rate of interest that banks charge to lend money to each other. More on that later, but first, the burning question …

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Who does it affect?

As a consumer, the BBSW rate is not immediately relevant. It does not directly affect your mortgage, credit card or savings account rate. It is used mainly as a benchmark for financial products such as business loans, currency derivatives and floating rate bonds.

However, an industry participant told The New Daily that, while the BBSW rate does not directly affect mortgages and credit card rates, a higher BBSW rate generally increases the cost of funds, which has a flow-on effect to consumers.

ANZ was accused of manipulating the bank bill swap rate. Photo: AAP

Now, back to how the BBSW rate works.

Why banks borrow from each other

Every day banks have a multitude of transactions to execute – payroll, retail and business purchases, credit card payments, etc – and no reliable way of predicting exactly what or how much those transactions will be.

Inevitably, some days banks find they have more money going out than coming in. On those days they simply have to borrow cash to meet their obligations. And where do you go to borrow cash? The bank.

The cheapest type of interbank loan is an overnight loan. The interest rates on these loans are based on the ‘cash rate’, which is set by the Reserve Bank of Australia (RBA) every month (currently 2 per cent).

The next cheapest way is through ‘short duration’ loans known as ‘prime bank paper’. These are loans that last between one and six months. The bank bill swap rate, or BBSW, refers to interest rates on these types of loans.

Last Friday, for example, the annual interest charged on a one-month loan was just above the cash rate, at 2.0683 per cent, while the six-month rate was 2.4167 per cent.

How the BBSW rate is set

Now brace yourself for the boring bit.

Unlike the cash rate – which is set by a council of wise owls at the RBA – the BBSW rate is set by the commercial banks themselves.

At the time of Westpac’s alleged rigging (2010-2012), the BBSW rate was set as follows:

Every morning at 10am, a body called the Australian Financial Markets Association (AFMA) would ask each of the ‘prime banks’ (the big boys) what interest rates they were offering or asking for that day. AFMA would then calculate the average, and that was the BBSW rate.

The trouble is it was possible for banks to lie to the AFMA, and thus manipulate the BBSW rate to their own advantage. This is exactly what banks in the US, UK and Europe did with their version of the BBSW rate, the London Interbank Offered Rate (LIBOR).

Money market traders have learned how to play the system. Photo: AAP

To avoid a similar scandal in Australia, AFMA changed the way it calculated the BBSW rate in 2013, so that it now calculates the average from actual market transactions – a much more reliable, if fiddlier, method. However, it is still possible to play the system.

What Westpac and ANZ allegedly did

The Australian Securities and Investments Commission (ASIC) claims the banks manipulated the BBSW rate to serve their own interests, but not by lying to AFMA. Rather, it says they artificially controlled the supply of prime bank paper during the five-minute window when AFMA took its readings.

Interestingly, though, ASIC says they did it both to increase the BBSW – i.e. make borrowing more expensive – but also to decrease it – i.e. make borrowing cheaper, depending on whether they were in debt or surplus. So in a perverse and convoluted sort of way, this alleged dishonest behaviour at times may have actually helped consumers pay their bills.

But that is not the point. The point is that if the BBSW rate is not a reliable indicator of the value of short-term loans, then the entire financial system will be destabilised, as so many other financial rates are based on it. It also raises questions about the general culture at the big banks.

It should be noted, though, that Westpac and ANZ deny any wrongdoing.