Exploring the LIBOR Scandal and Its Implications - Case Study Example

Exploring the LIBOR scandal and its implications Introduction The LIBOR or the London interbank offer rate is an interbank market borrowing rate that is currently given by a sixteen member panel of banks. Raskin and Cheun (2008) explain that the the membership of this panel comprises of 10 banking institutions in United Kingdom, United States, Canada, and Japan. The Libor rate is an indicator of many aspects of financial services including the financial health of the institutions that set the rates. Other financial institutions in the United Kingdom use the LIBOR for mortgages, credit cards, student loans futures, swaps and options trading. Thomson routers are the collecting and calculating agent for this rate. Each morning at 11 am, the financial news and data provider collects and calculates the rate submitted by the participating banks in ten currencies and about fifteen maturities. The maturities range from a single day or overnight to a whole year. Between 2005 and 2009, investigations reveal that there was an attempt by traders of Barclays derivatives to manipulate the LIBOR rates. The aim of such action is to benefit unfairly from trading positions based on false information about the financial health of the firm. In this inquiry, Barclays is found to have committed two forms of manipulation. The investigation conducted reveals that Barclays did benefit from the trading of its derivatives based on false information and the bank also used the same information to protect its image in the wake of the financial crisis. This paper reviews the modalities and process that participating banks set their LIBOR rates and the purpose of the same. It also looks at the broader impact of the rate in the commercial sector and its impact on consumers. Making of the LIBOR scandal The LIBOR scandal involved the collusion of the five major banks in the UK to manipulate the interbank offer rates between the years 2005 and 2009. The major culprit was Barclays Bank. The traders of its derivatives sent out requests during this period for the submitters of its LIBOR rates to falsify this information. The aim of such request was to ensure that the derivatives of Barclays Bank that were being traded at that time do not make any losses. The investigators also realized that Barclays got into the manipulation to save face in the wake of a financial distress it was undergoing (Giroux 2013, p. 345). Following this request, the other bank within the panel joined manipulation of the LIBOR rates begun. An enquiry into this practice was put up developing a number of recommendations to regulate the sector. A new institution was enacted to replace the initial regulating authority and legislations that provided for tighter control of the same. Overview and composition of the panel In the interbank market, the LIBOR is the mean rate at which these banks can offer each other money. This borrowing is usually in the form of unsecured loans. It is often calculated from a selected number of banks known as panel banks. The panel banks are usually selected by ICE Benchmark Administration and the Foreign Exchange and Money Markets Committee on a yearly basis. Since the rates are given for different currencies, there is a panel set up to calculate the rates for each currency. The major currencies involved in this calculation include the sterling pound, the US dollar and the Japanese Yen. Each panel consists of a number of experts drawn from different banks and consists of at least eight to 16 members. This is seen as a representative of the London money market (Raskin and Cheun 2008 p. 1). The banks that are selected to join this panel are selected based on strict criteria set by the administration of LIBOR. The criteria include the banks reputation, the market volume and the knowledge of the currencies operated under LIBOR. The concept of bank’s reputation is based majorly on the compliance to the law. Offences like association with money laundering or rigging of interest rates damage the reputation of banks and shows that these banks are not law compliant. In this case, the compliance to the law means that the likelihood of scandals to occur is limited due to the high level of discipline. Another perspective that will lead to a high reputation of a financial institution is the capital strength. In this perspective, stand-alone banks do not score since their capitalization is limited (Barnett and Pollock, 2012, p 286). Ordinarily interest is a product of the bank loan and the amount of the interest rate. However, in calculating the interbank interest income, the banks market share is quite important. The calculation is done by applying its market share on the loan and the interbank rates of interest (Rossi and Rochon 2003 p 166). This is the reason it is essential for the ICE Benchmark administration and the foreign exchange and money markets committee to consider the market share of the banks as a criterion for selection in to the panel. Calculating the LIBOR Thomson Reuters is the agency that is charged with the task of collecting and calculating this interest rate. The LIBOR rate is not a derivative of any set of transactions in the banking system, but it is an answer to a question regarding interbank market borrowing. Each morning, the panel banks have to answer the question of how much interest rate can they charge other banks on loans maturing at different time frames. This is usually done on a daily basis for each working day. The maturity periods offered within this interbank market range from one day to twelve months. The collection is usually by 11:00 Am London time each working day. After this collection, a removal of fifty percent of these rates from the list is done. The top 25% interest rates are left out, and so is the bottom 25%. The remaining 50% is used to calculate the LIBOR. This is basically the average rate of all these mid-rates that remain after the elimination of the top and bottom 25% for each currency (Fabozzi and Fabozi 2007, p. 92). Implications of the LIBOR One of the common uses of the LIBOR rates is the determination of the interest swap rates. As compared to many common money market rates in use today like the treasury rates and federal fund rates, the LIBOR rates prevail over all these rates (Ho, & Lee, 2004, p. 157). This is because of the fact that a swap occurring between two banks should be within the initial interest rate agreed on by the interbank markets. A swap is more or less similar to interbank money transfer. In this form of contract, the two parties agree on the start date and the interest that the money will attract (Hull et al, 2003, p. 81). The contract borrows its interest rate from the LIBOR rate of the day and is paid on monthly basis (Kwok 2008, p 26). This is done in the exact currency as that of the swap. The result will be disadvantageous to the small financial institutions that engage the big banks in swap agreements. The idea behind this is that the big banks set the rates too low but still benefit in swap agreements with the smaller financial institutions. Brooks and Chance (2015 p 405), opines that the implication of high-interest rate is that the financial institution is publicly acknowledging financial distress. This will cause a general public to shy away from its derivatives. The result is a reduction in the prices which can lead to greater loses if the condition persists. On the other hand, the situation is likely to improve on lower interest rates. This is because of the public confidence in the financial health of the institution. It should be noted that most financial analysts treat this information as an indication of the financial health of the institution (Coyle 2002, p 116). Apart from the financial position of the banks, the LIBOR is closely linked to the discounting of derivative prices. According to Okane (2013, n.p), states that the LIBOR remains the benchmark rate of reference index for all of the worlds major currencies. There are several use of the LIBOR rates in the financial and commercial sectors. These ranges from benchmarking commercial bank loans, student loans and even the sharia-compliant banks use it. The reason for this is that the rate has been known as the market rate over a long period (Khan 2013, p 315). When a manipulation occurs on this rate, there are a number of adverse effects in the commercial sector ranging from low returns to illegal benefiting from trading or contracts like in the case of swaps. Conclusion The LIBOR scandal brings to life a number of financial issues that require tighter control. First in the determination of the benchmark rate of borrowing, there is need to devise methods that will protect the rate from manipulation. An area that can be improved in this is to increase the number of participants in the panel. Transparency of the foreign exchange and money markets committee is another area that could be improved. However, all these remain just suggestions on the way to improve the efficiency of the financial sector. Reference list BARNETT, M. L., & POLLOCK, T. G. (2012). The Oxford handbook of corporate reputation. Oxford, Oxford University Press. BROOKS, R. & CHANCE, D. (2015). Introduction to derivatives and risk management. London. Cengage learning. COYLE, B. (2002). Bank finance. Canterbury, Financial World. FABOZZI, F. J., & FABOZZI, F. J. (2007). Fixed income analysis workbook. Hoboken, N.J., J. Wiley. GIROUX, G. A. (2013). Business scandals, corruption, and reform: an encyclopedia. Santa Barbara, Calif, Greenwood. HO, T. S. Y., & LEE, S. B. (2004). The Oxford Guide to Financial Modeling Applications for Capital Markets, Corporate Finance, Risk Management and Financial Institutions. Oxford, Oxford University Press. Hull, J., Treepongkaruna, S., Colwell, D.,Heaney, R. And Pitt, D. (2013). Fundamentals of Futures and options markets .Sydney. Pearsons education publishers. KHAN, M. A. (2013). What is wrong with Islamic economics? analysing the present state and future agenda. Cheltenham, Edward Elgar Pub. Ltd. KWOK, Y.-K. (2008). Mathematical models of financial derivatives. Berlin [u.a.], Springer OKANE, D. (2013). Modelling single-name and multi-name credit derivatives. Hoboken, N.J., Wiley Raskin, M. And Cheun, S. (2008). Recent concerns regading LIBOR’s credibility. Market source: indepth analysis. Retrieved on 2/2/2015 at Rossi, S. And Rochon, L-P. (2003). Modern Theories of Money: The Nature and Role of Money in Capitalist Economies .London. Edward Elgar pub. Read More