The Informational Role of Bank Loan Ratings: barclays libor manipulation - Research Paper Example

? BARCLAYS LIBOR MANIPULATION Nabila Obaid Al Shehhi Timothy Strother. Affiliation) Dedication I dedicate this work to my family who offered the moral support, my supervisor who guided me in my research. Above all, I want to thank the almighty God for giving me all the strength I needed and keeping me health. (I)Declaration This thesis is my original work and has not been presented for a degree in any university for any award to any examination body. I confirm it is my original work to the best of my knowledge. NAME: SIGNATURE DATE This project has been carried out under the supervision of (INSERDT SURPERVOR NAME) of behalf of (INSERT SCHOOL NAME) SIGN DATE (ii) Acknowledgement I wish to acknowledge all the people who supported me to ensure successful completion of my course plan. I also thank my cliques and friend for their support moreover my supervisor. TABLE OF CONTENTS Declaration 2 Dedication 3 Acknowledgement 4 Table of content 5 1.0. Abstract .6 2.0. Introduction 7,8 3.0. Literature Review 9,10,11,12,13 4.0. Methodology 14,15,16,17 5.0. Results 17 6.0. Discussion (including conclusions and recommendations 18, 19, 20 7.0. List of references 21, 22, 23 8.0. Appendices 1.0 ABSTRACT From 2005 to 2008, some banks are accused of Libor manipulation by submitting lower borrowing cost rates than the standard Libor quotes set by The British Bankers Association (BBA) during the financial crisis, however, UK and US Authority's action was absent at that time. On July 7, 2012, The Economist printed an article that, Barclays became under the spotlight for attempting Libor manipulation and has been fined around $450 million by UK & US regulators. In this paper, the major highlights and study will include the following: 1) Definition and comparison between Libor and Eibor rates. 2) When did Barclays join the 12 financial institutions that set Eibor rates? 3) How Barclays attempted Libor Manipulation Scandal. 4) What hypothesis and models can be developed to test Libor and Eibor rates 5) what results were found after measuring Libor and Eibor rates? 6) How such attempt can impact on prices and other financial institutions. 7) What are the solutions or alternatives to solve this problem and how others assumptions can help in reducing such financial fraud towards economy. 8) What are some recommendations, observations and comments of other researchers, economists, analysts and politicians? Finally, we present a paper that has remedied that can solve the problematic question at hand. This study presents an analysis that addresses the possibility of Libor manipulation and collusion by Barclays bank. 2.0 Introduction Libor is an acronym of the word London Interbank offered rate. This is the rate at which, a bank can borrow funds from other banks, in the interbank market. The Britsh Bankers Association controls the rate at which the bank can borrow daily. The loan is derived from credit worthy banks deposit whose maturity ranges from two weeks to one year. On the other hand, Eibor means Emirates Interbank offered rate. This is charges placed by banks in the United Arabs Emirates on interbank transactions. This is the rate, which the bank places on all transactions with borrowed money in the reserve. The main function of this financial tool is, to regulate the interest and the rate of money supplied into their respective economy. Today, Libor's primary function is to provide a point of reference for unsecured loans between London based banks. Barclays bank in Britain has in the recent tried to manipulate Libor for it to gain more during the financial crisis. This has been possible because Barclays bank is among the 16 banks that are selected to provide a daily quotation for calculation of Libor. The Libor is supposed to measure the rate at which large banks can borrow unsecured funds from other banks at various short-term maturities, and for a variety of currencies. On a daily basis, the 16participating banks are surveyed by the British Bankers Association (BBA), and submit sealed quotes, which answer: “at what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11:00 a.m. London time?” The Libor is then computed by averaging over the middle eight quotes and disregarding the four highest and the four lowest Several global banks got involved in the recent case of Libor manipulation, which has become a very serious issue for UK and US regulators. In this paper, major highlights will be how Barclays attempted Libor Manipulation Scandal. What are some economists, analysts and politicians observations and comments, what the consequences were developed for investors lending, consumers borrowing and economy as whole, who are other global banks involved and what solutions or alternatives found to solve this problem and how others assumptions can help in reducing such financial fraud towards economy. To develop a clear picture about this major issue, there should be a clear understanding of the meaning, of Libor rate and how is measured. Libor rate represents the London interbank offered rate set by British Bankers Association (BBA) and it measures the borrowing cost between banks and interest rates worldwide. Libor rate is involved in major loans, mortgages and derivatives and interest rates change due to Libor rate fluctuations, according to that, consumers monthly interest rate payments increase or decrease, while investments and mutual funds' appetite becomes high or low towards increasing or decreasing Libor rate as their earnings in interest may goes up or down. Barclays Bank committed a financial crime after financial crisis occurred when they manipulated with Libor rate due to fear of losing their investors in the competitive markets. After their fall was announced, many other global banks were also questioned such dirty practice by official regulators, such as, UBS, Citigroup, JP Morgan Chase, HSBC and Deutsche Bank. This concept is similar to having an inside information of future trade that affects security in the stock market in advance to make higher profit which is prohibited and against the code of ethics and considered as cheating. Based on the results of economists, analysts and regulators, Barclays exhibited the different type of artificial rate setting for their products to compete markets. They lowered the Libor rate to get a higher price on their debt to make their banks balance sheet during the crisis. The dangers and dishonesty became obvious, fined the bank around $450 million by UK, US regulator, more tightened the regulations immediately, and Libor should be set under actual not estimated borrowing costs in the future. However, setting Libor under actual borrowing costs might be complicated because when markets are illicit to do comparisons, there should be an estimated data of hypothetical figures to develop the benchmark and in this case, manipulation occurs. This whole process of banks charging interest rates on lending and borrowing should be checked and monitored by regulators all the time and justifications should be produced to avoid future negative circumstances. The contribution of fixing the Libor rate done by banks was somehow adopted from the Federal Reserve which contributed in fixing interest rate by lowering it in order to help in decreasing inflation and fix the economic crisis and raising the bonds value to increase capital gain. The financial collapse will remain if fixing interest rates will continue by the Federal Reserve and private banks so there should be a solution to minimize this practice and get to a global agreement with, to prevent fixing interest rates for capital gain purpose. 3.0. Literature Review A. BANK REPUTATION, CREDIT RATINGS, AND THE COST OF CAPITAL The banking industry is diversified and very competitive and requires every bank to maintain a good reputation among the public eye. On top of that, to be, competitive and lower down the cost of running capital to maximize the profits. Reputation is a great factor for any bank to survive in the competitive market. Johnson (1977) examines the importance of reputation to any bank. He evaluated changes and trends on banks during loans announcements. He found that those banks that had good reputation had a better chance at attaining loans and all stakeholders in the industry had confidence in that particular bank. He also noted that banks, which had a negative reputation, tend to keep away bank market players. This is because of the negative reputation that is attached to them. According to Livingstone and Miller (2002) says that bond under righter’s that have high reputation lowers the under righting fee providing competitive prices. Hubbard el at (2002) took samples of mortgages and bank loans to evaluate what were the implication of stable financial accounts on loans after controlling the information on borrower’s rates. The results of this were that banks that have low capital charge high loan rates compared to well capitalized banks. This is because of individual bank on the likely information on loan rates. According to BBC Barclays bank manipulated the benchmark set by Libor. This was motivation intended to increase it trading position and overall perception of it financial status. This helped the bank to trade unfairly and gave false information of it actual status. It was reported that between August 2005 and May 2008, certain traders were in touch with financial institution that trade in Libor and Euribor. The main aim was to request them to submit rates that would be more favorable on their side. In other terms presentation of false facts about their financial position. Barclay’s employees are said to have fallen in for this trap and the bank actively participated in this. It was in 2012 that the issue came to be known. Cost of Capital Capital cost is affected by individual’s bank reputation. This is achieved through careful implementation of effective policies. Ederington el at (1987) showed that bonds yields more on banks that have high credit rating, accounting ration. These results suggest that marketers try hand to participate in all manner of managerial and non-administrative moves in maintain high reputation and gaining the desired reputation. Because of this, more confidence is built up and the trading is high enough. Although the actual image of Barclays bank was not the one that was being displayed. Narayanan, Rangan (2007) shows how commercial banks have used all methods to enhance their financial image to the public. They do this by allowing extension of bond underwritings activities to favor their interests. In the absence of bond market reputation, a strong private debt market reputation enables commercial banks to win underwriting mandates from loan clients. There are several common approaches to detect manipulation markers. They include searches for distortions in prices that cannot be explained by seasonality, a common explanation for price changes in commodities markets. A very common “red flag” for manipulation in commodities futures markets is backwardation, i.e., a condition where a futures price is lower 9 than a spot price, an inversion from the typical canting relationship. While episodes of backwardation can occur in the absence of manipulation, (e.g. when supply is unexpectedly unable to meet demand despite the presence of competitive market conditions), such episodes generally do not last for a long time. Recently, Abrantes-Metz and Addanki (2007) developed a new method to screen for manipulations in commodities markets. They hypothesized that manipulation induces noise in the market and distorts market expectations about future prices. By using the futures price as the market expectation for the future spot price, and by applying their model to a well-known episode of manipulation that occurred in the silver market in 1979 and 1980, they found that manipulation induced more volatile market forecasting errors regarding future prices. Manipulation in the stock market, as in the commodities markets, can assume various forms. For instance, insiders may take actions that influence stock prices through accounting and earnings manipulation, by withholding critical information that is expected to influence stock prices prior to the granting of options, and by disseminating misleading information and/or rumors while backdating stock options. Aggarwal and Wu (2003), Heron and Lie (2006) and Goldberg and Read (2007) present such screens. Harrington (2006) asserted that certain “collusive markers” are more likely to occur when price fixing conspiracies exist than under a competitive setting. A price-fixing conspiracy is defined as an agreement between cartel members on one or more terms (most commonly, but not always, the price term) that is (are) fixed for a common product. More often than not, cartel members also agree on market share rates, as well as on punishment mechanisms for members who deviate from these terms of agreement. Collusion in bidding activities has also been observed from time to time. In this study, such techniques are applied to screen for collusion in the establishment of Libor. The collusive markers for price that are typically utilized are: (a) higher than expected average prices, (b) reduced price variations across customers, (c) declines in imports on substitutes, (d) prices that are strongly positively correlated across firms, (e) a high degree Of uniformity across firms in product price and other dimensions, (f) low price variances. (G) Abrupt changes in price that cannot be explained by demand and/or cost movements. In addition, the collusive markers for quantity that are typically utilized are: (a) market shares that remain highly stable over extended periods of time, and (b) market shares between firms that are negatively correlated. Finally, Benford’s law has also been used to detect data tampering in taxes, in financial ratios, and in survey data. Newcomb (1881) and Bedford (1938) developed a mathematical law on the empirical observation. In many naturally occurring numerical data sets, the leading significant digits are not uniformly, distributed but instead follow a logarithmic weak Monotonic distribution. Applications of this stream of research include Judge and Schechter (2006) and Nigrini (2005). Hypothesis Manipulation is a vague term used in a wide and inclusive manner, possessing varying shades of meaning and usually conveying the idea of blame-worthiness deserving of censure. There is usually also an implication of artificiality and of skillful and ingenious management. In its most common use it has reference to a speculator, or to a group of speculators who buy or sell produce, in such a way as to give outsiders the impression that such buying or selling is the result of natural forces. Hence the term includes excessive speculation, the spreading of false rumors, the working of syndicates to increase or depress prices, ‘wash sales,’ ‘matched orders,’ and ‘corners.’ All of these notions – blameworthiness, artificiality, speculation, false impressions and rumors, collusion to affect price, and specific practices – are associated with manipulation, and each has held prominence in legal theory and in the law at some point. Scholars and observers have been encouraged to offer definitions, and resulting interpretations of the state of the law, but the only ground of agreement has proved to be the difficulty of proving manipulation. As one scholar has put it, “Manipulation is difficult to define . . . . Drawing a line between healthy economic behavior and that which is offensive has proved to be too subjective and imprecise to produce an effective regulatory tool.” Friedman (2011) by comparing the trader’s act to their behavior, without manipulative intent. He does so by comparing the behavior to “what the long [[trader] would have done if he simply did not take the anticipated impact into account,” and then, “what the long would have done had he put out of mind the additional pressure created by a system of punitive sanctions for default.” Of course, the more basic question is whether there is such a thing as manipulation at all. Fischer and Ross (1999) believe “legal prohibitions are unnecessary” in the futures markets. They claim that no objective testcan detect manipulation, and all subjective tests that find manipulation also find fraud.30 As a result, there is no manipulation beyond what the law of fraud can already address. They are skeptical that the existence of whole categories of putative manipulation, asserting that they are likely to be self-deterring: Manipulation requires buying for a lower price than one sells for, but most techniques for raising the price upon purchase will result in a lowered price upon sale. The manipulator would have to make more on the manipulation than they lose in transaction costs. They further emphasize that manipulation requires deployment of huge amounts of capital, that large positions are already largely prohibited by law, and that exchanges have an incentive to prevent manipulation. With no gainful manipulation detectable that is not fraud, Fischer and Ross (1999) urge an end to the definitional and regulatory enterprise. 4.0. Methodology and findings The methodology used to investigate in this paper is typically the one used to investigate UN ethical behavior amongst the market players, by the regulating body. We look into the structure that makes up the Libor and how the market players make it up. In addition, we try to investigate on how the banks have tried to manipulate the system. This paper starts by looking the makeup of Libor, and how it works. We analysis how the bank are able to get information on how to place rates. It clears from our finding that any bank is tempted to try to manipulate the Libor system to earn more public and sector player’s confidences. We found this unethical behavior. So far, three banks have confirmed that their top officers have been involved in manipulating the Libor system. Barclays bank has so far agreed participating in, Libor manipulation and has been fined by the UK and USA authorities for its actions (Yi Mullineaux, 2006). According to the Journal (Mollenkamp and Whitehouse, 2008), there is variances in individual bank quotes. This is after carefully investigating the patters of different patterns among various banks. It is noted that, quotes were unusually smaller and this is an indication they was manipulation somewhere. To investigate this non-market possibility, we have tracked the Libor, using as a methodology, the second digit distribution variant of Benford’s law. As a result, we have found that over an extended period there have been significant departures between the Benford and empirical second digit distributions. The behavioral departures of the Libor from the expected path, in particular a path that the Libor had followed for at least the prior twenty years, raise questions regarding the integrity and quality of its rate signals coming from individual banks and cry out for an answer. Based on our evidence, biased signals coming from the individual banks (agent aggregation bias), rate manipulation or collusion appear as one likely answer (Yi Mullineaux, 2006) Libor quotes are analyzed, from January 2007 until 2012. We also look into the market indicators both at Libor level and at each individual bank Libor bank level. This paper findings indicate that they is some questionable of Barclays level of Libor. This pattern suggests that they are manipulation into contrast of the financial health at a particular time. In this section of our analysis, we investigate the Journal's presumption that CDS spreads Serve as effective benchmarks for assessing the reasonableness of Libor quote data. According to The Journal, the borrowing costs of banks is presumed to be a function of their perceived conditions of solvency and financial strength. The prices of CDS contracts are also presumed to be a function of financial strength and, according to the Journal, thus serve as a useful indicator of the cost of borrowing. There are many reasons why significant discrepancies may exist between CDS spreads and short-term borrowing costs. For instance, the time horizons of interest may be different, i.e. a creditor may believe that a bank is fully able to meet its obligations over the next 30 days and thus may lend to it at a low rate during that time, but (s) he may doubt its ability to meet its obligations over the next five years. The two parties may also possess different sensitivities to market risk, and thus may command different (and differently evolving) risk premium. In addition, if the CDS market is segmented, there may be additional (and evolving) liquidity premium associated with a CDS contract. These (and many other) observations notwithstanding, it is evident ceteris paribus that a “more risky” bank should have higher borrowing costs and CDS spreads than a “less risky” bank, though any specific results should be interpreted with these caveats in mind(Schwarz, Krista 2010).. We also compare the ordinal content of the CDS spread data with the individual Libor quotes. Specifically, comparison for each period (a) the percentage of time each bank’s CDS Spread is less than or equal to the median spread, with (b) the percentage of time each bank's Libor quote is less than or equal to the median rate. We are interested in “outliers,” defined as banks that consistently offered “low” Libor quotes while featuring “high” CDS spreads(Schwarz, Krista 2010).. For example during a trading period Deutschbank meet this criterion; their Libor quotes were essentially always less than or equal to the median but their CDS spreads were never less than or equal the median. Bank of America is quite similar, with “low” Libor quotes 97% of the time but “low” CDS spreads only 2.6% of the time. Citigroup’s quotes were low 100% of the time, but its CDS spreads were low only 3.3% of the time.5 In sum, this cross-sectional analysis reveals that banks with low rate quotes do not necessarily enjoy low CDS spreads during the Period(Schwarz, Krista 2010).. For instance, the rate quotes of Citigroup and HBOS were low 93% and 54% of the time, respectively, but their CDS spreads were only low 8% of the time. The rate quotes of West LB were low 66.1% of the time, but its CDS spreads were only low 1.7% of the time. In addition, the rate quotes of JPM Chase were low 85.1% of the time, but its CDS spreads were only low 32.8% of the time.(Schwarz, Krista 2010). These results suggest that either (a) CDS spreads are not effective ordinal indicators of borrowing costs, or (b) this sample of banks is unusual and atypical in some manner that is not easily identified. Although this issue falls beyond the scope of our analysis, it should be noted that many of the “outlier” banks are relatively large as defined by their market caps. Very large banks appear to have borrowing costs that are low in relation to their CDS spreads. For example, the low borrowing costs of JPMorgan and Citigroup provide a potential explanation for the disparities found when comparing their CDS spreads with their quotes. Why is this true? One explanation is that larger banks may be able to obtain “volume discounts” and thus may be able to borrow at lower rates than smaller banks. Other explanations, of course, are possible as well, and deserve additional study in future research work. 5.0. Results This research finds that Barclays bank has been involved in manipulating the rates. This is against the set laws on regulating and governing the rates. Since 2005, traders have asked for favorable rates to benefit their financial position. We also realized that during the global financial crisis Barclays bank lowered them rates on submission to make them look more financially health. This was a manipulation against it actual position. We also found out that Barclays provided false submission to the regulating body at different times. This is motivated by trader’s position on derivative, reputation and generally the media negativity in Libor submissions. Barclays tried to hind this by manipulating the libor rates and it seemed to be health during the global financial crisis. This made market players have more respect and confidence in it because of their manipulating actions(Rausser, at al 2008).. It also came to our attention that between August 2005 and May 2008 traders was requesting libor that were helping to them. When the rate submitters took into account of the request then Barclays bank submissions were false and ill motivated (Rausser, at al 2008). It came to our knowledge that Barclay’s management directed that the bank lower it submission rates after a viral speculation of high U.S. rate submission. These directives resulted into false rates that did not reflect the actual submission rates on it perceived cost of obtaining interbank funds. (Rausser, at al 2008) 6.0. Discussion (including conclusions and recommendations) Barclays bank has been giving manipulated submissions to show a healthier picture of credit worthiness and it ability to raise funds. This was false from the actual contribution that was lower than the submission rate. Driven by the spirit of speculation on media it manipulated to show a healthier picture of it financial capabilities. Barclays was set out to impress and show out how healthier in terms of financial it was at a time of crisis. This occurred because of it being able to access the information on Libor. Manipulating Libor added a big advantage to the Barclays bank, as it was able to maintain a good picture in the eyes of the media, which was contrary with what was actually true. This was unfair dealing in the market at a time; the world was faced, with global financial crisis. Barclays manipulated rates for at least two reasons. Routinely, from at least as early as 2005, traders sought particular rate submissions to benefit their financial positions. Later, during the 2007–2012 global financial crises, they artificially lowered rate submissions to make their bank seem healthy. Impact of libor manipulation to other financial institutions Indicate again, why we are interested in tracking the Libor. Given its extensive use, with literally trillions of dollars of contracts benchmarked against it, the economic consequences of a misbehaving Libor can be various and severe. For example, from a distributive standpoint, if the level of Libor deviates from its market level, it will affect an artificial and inefficient redistribution of wealth from one group of people to another. If, for example, the level is too low, borrowers, such as homeowners, gain at the expense of lenders(Johnson, 1997). A more subtle allocate consequence is to distort other prices in the economy. A lower Libor induces a lower mortgage rate, makes it easier to buy homes, substituting homes away for other goods. This artificially inflates the prices of homes and related goods such as furniture, for example, while deflating the prices of other goods. The immediate implications of a non-market determined Libor, over a prolonged period, have the potential to lead to bubbles and meltdowns of the type we are currently experiencing. This brings us back to our earlier point, which is that we need objective-predictive ways to track the behavior (Johnson, 1997) How to solve and prevent future Libor manipulation They are various measures that can be taken to enhance Libor and prevent further manipulation. This solution offered is as result of extensive research. The first thing would be to increase the number of banks participating in libor process. This would in turn increase the number of banks affecting the final decision on rates, leaving no loophole for manipulation. Secondly banks should each day report about the trading activities, give maturity and actual borrowing of the previous day before been give a green right for that day. This meant those verifiable facts about the previous borrowing and how they expect the cost to increase (Ederington, et al, 1997). The other option would be that each individual quote should remain sealed for the longest time possible. This would increase confidentiality of borrowing cost. This information is very important to them because a bank uses this information to refuse to provide the information. This would remove the incentive to use the Libor quote as a (false) signal. Fourth, an agency (maybe the BBA, maybe another agency) will have to compute the Libor and monitor the quotes regularly. Notice that monitoring “expected deltas” for possible manipulation would imply the use of empirical screens to detect unusual patterns such as sequences of negative expected deltas or patterns of correlations across the participating banks. Empirical screens can be powerful in detecting alleged wrongdoing – after all, it was with these screens by outsiders that the alleged Libor conspiracy and manipulation was first flagged (articles by the Wall Street Journal in April and May of 2008, and Abrantes-Metz, Kraten, Metz and Seow in August 2008). Conclusion Barclays bank have accepted that it senior employees have been involved in manipulating libor. This act of manipulation for a bank to gain certain reputation should be highly discouraged. Heavy fines should be placed, upon all financial institutions that participate in this unethical busisseness. This is a very bad way of dealing, where one shows how health he is after taking advantage of others. Reference Abrantes-Metz, R. and S. 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