The fall of Bob Diamond

July 3, 2012, 8:52 PM UTC

FORTUNE — Bob Diamond’s resignation as CEO of Barclays, announced Monday at 11:51 PM London time, was practically inevitable given the rising furor over the LIBOR scandal from politicians and regulators. The British authorities were already bashing its banks for allegedly excessive pay and “casino-style” risk taking, and planning new rules far more draconian than U.S. reforms — including a proposal to “ring-fence” the retail business by separating it from investment banking.

For years, Diamond’s big pay packages and image as a Yank bringing Wall Street to High Street made him a top target. In fact, vilifying Diamond was always less than logical, since Barclays (BCS), unlike Lloyds and Royal Bank of Scotland (RBS), weathered the financial crisis without a government bailout. Diamond also transformed Barclays from a sleepy UK franchise into a world-class investment bank over fifteen years, standing virtually alone in doing it from scratch.

In fact, Diamond’s jaunty defense of the universal banking model he’d spent his career building only heightened the tension. It’s precisely that model that is now under siege. And the LIBOR scandal will make it far more difficult for the British universal banks to block or soften the most extreme proposals to limit their scope. It’s highly possible that, just as Diamond departs, his dream is dying.

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As soon as the $453 million in settlements with the CFTC, U.S. Justice Department, and Britain’s Financial Services Authority were announced last Wednesday, it was clear that politicians of all stripes wanted him out. The conservative government is championing economic austerity, a policy that leaves no room for the perceived excesses of banking. Its leaders came within inches of explicitly demanding Diamond’s ouster. Chancellor of the Exchequer George Osborne states that affair is “symptomatic of a financial system that elevated greed above all” and “brought economy to its knees.” Osborne demanded to know “what [Diamond] knew and when did he know it?” Prime Minister David Cameron stated that Diamond had “serious questions to answer” and that the government needed to trace the scandal “all the way to the top of the organization.”

On Wednesday, Diamond will appear before a committee of Parliament investigating the LIBOR scandal. The members are certain to grill him about one of the most mysterious aspects of the case, Barclays policy of falsifying its borrowing costs during the financial crisis to forestall rumors it was failing.

It’s important to understand the rickety, antiquated system for setting the London Interbank Offered Rate, and how that system practically invited abuse. Each morning, Thomson Reuters, on behalf of the industry group the British Bankers’ Association, polls a number of banks — around 18 during the “scandal period” from 2005 to 2009 — on the interest rate they’re paying to borrow short-term, for maturities anywhere from overnight to one year, for ten currencies. The numbers are provided by supposedly neutral, objective “submitters.” Thomson Reuters eliminates the 25% highest and lowest numbers, and takes an average of the eight in between. That average fixes the LIBOR rates for the day.

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The rates submitted by all the banks, not just the averages, are public information. They’re published on Bloomberg, for Barclays, Citi (C), RBS and the other banks, every day around noon.

During the financial crisis, according to the findings of the CFTC and other authorities, many of the banks were submitting rates far lower than their actual borrowing costs. The reason was simple: They feared that by showing rates far above those of their competitors, they’d spark rumors they were facing a liquidity crisis. In 2007, Barclays was providing accurate data that showed higher borrowing costs than its peers, and was alarmed that those numbers would alarm investors and regulators since its peers were cooking their numbers.

Diamond addressed the issue in a letter to the Chairman of the committee he’ll face on Wednesday. “The unwarranted speculation regarding Barclays liquidity was as a result of its LIBOR submissions being high relative to those of other banks. At the time, Barclays opinion was that those banks’ submissions were too low given market circumstances. This raised questions for the bank about the integrity of the LIBOR setting process.”

According to the U.S. Department of Justice settlement, Barclays adopted a policy of submitting artificially low numbers in August of 2007. One “submitter” stated that the bank needed to be “part of the pack” and another cautioned the importance of holding its “head below the parapet” so that it did not get “shot off.”

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What’s certain to attract questions from the panel is a conversation between Diamond and a Deputy Governor of the Bank of England on October 29th, 2008. The details are given in a report Barclays submitted to the committee. The bank official was concerned that Barclays relatively high submissions might signal distress. According to a note Diamond made after the conversation, the official stated that “while he was certain we did not need advice, that it did not always need to be the case that we appeared as high as we have recently.”

According to Barclays documents, Diamond discussed the conversation with his chief operating officer of the investment bank, Jerry del Missier. Diamond did not think he had received instructions to artificially lower submissions from the Bank of England. He also denies instructing del Missier to lower the data. But del Missier “concluded that an instruction had been passed down from the Bank of England not to keep LIBOR so high. He passed down an instruction to that effect to the submitters.”

The Barclays documents portray the incident as a case as a misunderstanding between Diamond and del Missier.

But it certainly sounds as if the Bank of England encouraged Barclays to lower its LIBOR submissions. The scandal could potentially reach beyond Diamond to the bank-skewering regulators themselves. The incident will undoubtedly provide still more material for what’s been a regular spectacle, high drama in Parliament, with Bob Diamond at center stage.