Money Laundering, Transfer of Funds from Sanctioned Countries and Excessive Risk by JP Morgan - Assignment Example

Money Laundering Money laundering means concealing the money which has been obtained by illegal or illicit means. The money which is usually laundered is either corruption money, money earned through illegal activities like smuggling or drug trafficking. Money laundering occurs in three steps: placement, layering and integration. Placement means introducing the cash into the financial system by some method. Layering involves a set of complex financial transaction which ensures that the real source of the money is hidden if any investigation takes place. The final step involves acquiring the money from the various transactions done earlier. (Rösner, 2010) There are many ways in which money laundering is carried out such as surfing, casinos, real estate, fictional loans etc. The bigger worry is that not only are unscrupulous individuals involved in money laundering but many large banks in USA are also involved in this illegal practice. One example which comes to mind is case of Raul Sinas in which Citibank was involved in money laundering of more than $200 million. Many attempts have been made by the United States regulatory authorities to control dirty money from entering US soil. Anti-money laundering act and the Bank Secrecy Act are the main vehicles which help the government to control money laundering. These acts require financial institutions such as banks and credit card companies to report transaction which are in excess of $10,000 and also report any financial activities which appear suspicious to the bank authorities. (Rösner, 2010)The Financial Crimes Enforcement Network or the FinCEN maintains financial databases on the basis of record submitted by banks which are them made available to criminal investigators .What is lacking in the fight against money laundering are not the laws but the will on the part of the bank as well as the states to stop money laundering. Transfer of funds from sanctioned countries United States of America puts a number of financial restrictions on many countries. These restrictions are placed in order to strangulate these countries and to stop their anti-US or inhumane practices like genocides. Some countries on which financial sanctions have been placed include Cuba, Congo, Iran, Myanmar, North Korea, Sudan and Syria. As a part of sanctions, no company operating in USA is allowed to sell products to them (in some cases the sanctions are only on certain products).Also US banks are not allowed to receive transactions originating from these countries. However these countries regularly find a way of circumvent the transactions, buy products that they need and also pay for them. Money launderers provide invaluable help in making these payments. They are experts in making the money enter the financial system and thus banks may not even be aware that the money they are receiving comes from sanctioned countries. Another method regularly used to move money from these countries in to USA is the ‘hawala’ system. Hawala system originated in the Indian subcontinent but is now used all over the world for moving illicit money. (Teohari, 2004)This system is notorious for its efficiency. In spite of many laws all over the world, the system remains intact and running. Excessive Risk by JP Morgan JP Morgan declared in May 2012 that it had lost over $2billion in trading. Although the amount itself was not big compared to the size of the bank but coming just after the financial meltdown of 2008 the loss raised big concerns among investors as well as regulators. If the bank could lose 2 billion, could a number of banks losing the same amount trigger another financial crisis like the one in 2008? The focus through this loss returns to huge and risky transactions which were responsible for the 2008 crisis. Regulatory reforms like the Dodd-Frank Act and the Volcker rule were made in order to prevent speculative trading by the banks. (Garcia, 2011) However the implementation of Dodd-Frank Act has left a lot to be desired and the Volcker rule is still being debated and has not been implemented. Volcker rule has been made to ensure that hedging takes place only to ensure the safety of bank’s investments and not as a tool to make money. However the problem remains in identifying what is hedging and what is speculative trading. The office of the Comptroller of Currency had deployed around 100 examiners at JP Morgan but they failed to detect or prevent the losses which the bank recently suffered. Although the Senate Banking Committee is conducting an inquiry in to the losses but it seems no regulatory solution is in sight which can prevent hedging from degenerating into speculative trading. Volcker rule is the only relief in sight but given the huge opposition from traders and banks it seems likely that it will be implemented any time soon. Credit Rating Agencies and the US crisis Credit agencies have been accused of playing a leading role in the subprime crisis. These rating have been criticised for giving AAA rating to products like mortgage backed securities and collateralized debt obligations. In the absence of these rating not many investors would have purchased these securities and would have been prevented from the subprime crisis. As the rating agencies were trusted by the investors the magnitude of the crisis was magnified many times. These rating agencies were paid by the same companies who were evaluated by the agencies. Thus there was a clear conflict of interest in giving bad ratings. (Hoffinger, 2009) The high amount of competition among the credit rating agencies also ensured that the standards of rating were constantly downgraded in order to lure more customers. After the subprime crisis the US Securities and Exchange Commission looked in to the working of the rating agencies and have recommended far reaching changes such as prohibition from rating a structured product without the information on underlying assets, additional internal monitoring and third party reviews of the rating process. Calculation of LIBOR LIBOR stands for London Interbank offer rate. This rate is a reflection of the interest rates which are being charged by the major financial institutions of the world. It is calculated everyday by Thomas Reuters for British Bankers Association. The process of calculating LIBOR starts everyday at 11 AM London time. The banks which contribute to setting of LIBOR send their inter banking borrowing rates to Thomas Reuters confidentially at 11 AM. (Rebonato, 2002)This process is followed for about 15 borrowing periods and 10 currencies. The number of banks which participate in this exercise varies according to the currency, for e.g. the Euro panel has 15 banks and the US Dollar panel has 18 banks. The borrowing period also vary from 1 day to 12 months. After receiving the inter banking borrowing rates from the banks in the panel , Thomas Reuters discards and top and the bottom quartiles and then uses the middle 2 quartiles in order to calculate the average. This average is usually called as the shaved mean or the trimmed mean. LIBOR rates are then published by around 11.30 AM for all the borrowing periods and all the currencies. Apart from publishing the 150 LIBOR rates, Thomas Reuters also publishes the data which was submitted by each of the individual banks. Any bank can apply to join the LIBOR panel it is not required for the bank to be present in London. (Rebonato, 2002)Banks for the processes are selected on the basis of their market activity.BBA also publishes the methods used for selecting the banks in order to ensure full transparency and impartiality in the setting of LIBOR rates. Importance of LIBOR LIBOR rates were first developed in 1980s.At that time London was fast emerging as the world financial centre where 20 % of international bank lending as well as 30 % of foreign exchange transactions was taking place. LIBOR was the answer to the demand for an accurate borrowing rate for the banks. LIBOR is important as it is used for a large number of financial instruments. The rates are used for syndicated lending, commercial lending as well as for residential mortgages lending. Banks usually use the LIBOR rate as the base and add some interest on top according to the creditworthiness of the borrower. Thus LIBOR rates basically decide the rate at which ordinary individuals can get car loans, credit card loans, savings as well as houses. LIBOR sets the rate for about $800 trillion worth of financial products which is about 10 times the size of the world economy and hence it stays very important to this day. (Rebonato, 2002) Apart from setting the interest rates for practically every mortgage, derivatives based on LIBOR are traded on the Chicago mercantile exchange, LIFFE and also over the counter. LIBOR rates are also used as a very common indicator of the reaction of global markets to the prevailing economic conditions. As they are widely reported all over the world , so they also act as a cue to the stock markets all around the world and can mar or make the equity markets of not just London but many countries. Thus LIBOR rates are very important not only to the financial and banking world but also to the common public. LIBOR scandal At present Barclays bank along with 15 other global financial institutions are being investigated by authorities in United States, UK, Switzerland, Canada and Japan for manipulating the LIBOR rates. Some people claim that these manipulations have been going on for as far back as 1991.Barclays; UBS and several other banks have been fined for these manipulations which investigations have revealed that the LIBOR panel banks used to work as a cartel on many occasions in order to rig LIBOR. Rigging of LIBOR took place due to 2 reasons. One was that banks have been allowed to do derivative trading. (Miller-Jones, 2012)So the derivative traders used to ask the employees responsible for setting LIBOR to report rates which will give them huge profits on the derivatives trade, not the actual rates at which they were borrowing or lending. As many derivatives were tagged to the LIBOR base rates, the traders could make a killing with these manipulations. Traders not only asked their own bank employees to submit false rates but also coordinated with many other banks in order to alter their rates as well. Thus LIBOR was moved up and down by the banks entirely based on the position that traders took and not on the actual borrowing rates. The arrest of a trader Thomas Hayes has revealed that UBS booked profits in hundreds of millions by the manipulation of LIBOR. Thus what happened here was that banks paid more attention to their bottom line then to ethical banking. As they were hard pressed to show results, they used any method which was available. Manipulation of LIBOR was easy because the bank was not only setting these rates but was also trading in derivatives based on these rates. There was a clear conflict of interests here. The second reason for LIBOR manipulation occurred during global financial meltdown which started in 2008.This was an unstable time for all financial institutions of the world as world economy was on a downward spiral. During this time banks pulled LIBOR downwards. When the bank tells that it can borrow money at relatively inexpensive rates from the market it gives the signal that it is less risky and the financial meltdown has not affected bank much. This message is beneficial for the business of the bank. (Miller-Jones, 2012) Manipulations of LIBOR meant that the investor confidence in the financial markets will decrease to a very low level. If the investor cannot trust the rate at which banks are lending to one another it leads to distortion of the market. It also created an unfair market in which the insiders in the know of the manipulations made a lot of money whereas those outside the loop lost money. It is a lot like insider trading and is a criminal activity. The hardest hit in this scandal were the retail investors who had no clue about the manipulations going on and trusted the LIBOR to make their investments. Slow Regulatory Reaction Mervyn King, the governor of Bank of England gave the following statement in 2008 in Parliament – “LIBOR is actually the rate at which banks do not borrow from each other.”This shows that the Bank of England was aware of LIBOR rate manipulations which were taking place in the market. The question which arises is why were the authorities slow to act or to impose penalties on these violations. FSA or the Financial Services authority of London has publicly acknowledged that it was slow in reaction to the LIBOR scandal. Reports about the scandal emerged as early as 2005 but action was taken only after a number of years had passed. Even then people have been angry at the amount of fines which have been imposed on banks. Barclays has reported a profit of 6 billion pounds even after paying the amount as a fine. The main reason which comes to the fore for the slow reaction the LIBOR scandal is the financial meltdown which started in 2008.After the financial meltdown the FSA and other regulatory authorities were too busy dousing the fire caused by the financial meltdown and were not paying much attention to the LIBOR scandal. The fact that LIBOR manipulation could be one of the reasons for the financial meltdown was inconsequential at that point of time. (Miller-Jones, 2012) The second reason for the slow reaction has been the sheer size of the banks which are involved in the scandal. As the banks are very large in size and their influence, the regulators cannot simply shut them down. There is no one to replace the banks with. At the time of global financial meltdown when businesses are hard pressed to obtain credit, a harsh penalty on some of the biggest banks of the world will have severely dented investor confidence as well as economy of all the western countries. A breakdown of the banks means a breakdown of financial system. The economy of a country cannot grow in the absence of a robust and well defined financial system. This is the reason why actions have been taken against individual traders who were involved in LIBOR manipulations but the banks have been allowed to escape with small fines. (Miller-Jones, 2012) Although fines appear huge when they are looked at but compared to the size of the banks we are dealing with, the fines are minuscule and will not affect the long term survival of these banks. The LIBOR scandal was as much a regulatory failure as a case of fraud by the banks involved .So the regulators have been more focused on plugging regulatory loopholes in order to ensure that the fixing of LIBOR rates do not takes place in the future and ordinary people are not cheated of their money. LIBOR Reforms Following the LIBOR scandal, the UK government set up the Wheatley review under Martin Wheatley, the Managing Director of Financial Services authority. On the basis of the recommendations of the Wheatley review, the financial services Act was passed which made major changes in the fixing of LIBOR rates. The Wheatley review came to the conclusion that the main reasons for the LIBOR scandal were lack of transparency, accountability and overreliance on the banks. (Miller-Jones, 2012) Many changes have been suggested in order to ensure that future manipulations of the LIBOR are not possible. The first change which is taking place is that a new independent body has taken over the responsibility for the administration of LIBOR and also a code of conduct has been made which will strictly govern the LIBOR submission process. The new body is the Financial Conduct authority (FCA) which has replaced the Financial Services Authority (FSA) from 2013.The submission as well as the administration of LIBOR will now be governed by the FCA. Along with this, the key individuals which are responsible for the submission of the LIBOR rates will now be watched by the FCA. It has to be noted that the derivatives traders were able to manipulate rates as they had access to people who were responsible for setting up of LIBOR rates. Banks have been asked to ensure that not even top management of the banks are able to influence these individuals.FCA has also been made a statutory body which will allow it to bring up criminal charges if any manipulation of LIBOR is reported. Being a statutory body, FCA can force the banks to submit LIBOR fixings and also the transactions supporting such fixings. (Miller-Jones, 2012) The financial services act has made LIBOR a regulated benchmark; it has also given government the freedom to include any other benchmark as a regulated benchmark in the law in order to take care of any future benchmarks like LIBOR which may emerge in the financial world. LIBOR was after all introduced only in the 1980s, there could be any other benchmark invented in future which could have wide ramifications like LIBOR. It has also been stated that LIBOR submissions need to be backed by transaction data as far as possible. In order to ensure this, the FCA has decided that LIBOR rates for 4, 7, 8, 10 and 11 months are to be scrapped. Apart from this LIBOR rates will now be reported in only 5 currencies – sterling, euro, yen, Swiss franc and the US dollar. The other LIBOR benchmarks have been eliminated due to their limited use and the lack of transaction data to back up the figures. The final change is that British Bankers Association (BBA) will no longer be administering LIBOR calculations. The new LIBOR administrator will be approved by the FCA and also the manager who sets the LIBOR process will come under FCA purview. There will also be an oversight committee which will consist of LIBOR users, submitting banks, infrastructure providers and at least 2 independent members. This oversight committee will look into the LIBOR setting process and will report discrepancies if any are found to FCA. Submitting banks which are on the LIBOR panel have also been asked to carry out an internal as well as external audit of their LIBOR submitting process in order to prevent the chances of manipulation by the banks or some unscrupulous traders. Thus many measures have been taken to ensure that LIBOR is not manipulated in the future. However the biggest and the most effective measure which has not been taken could be the separation of investment banking arms of the banks from their banking arms. As long as these two branches come under the same management, we are looking at another manipulation down the line. The amount of money to be gained by manipulation is simply too high and the corresponding punishments do not look severe enough. Bibliography Susanne Rösner, 2010. Money Laundering. Edition. GRIN Verlag. Leo Teohari, 2004. Hawala: Based on a True Story. Edition. PublishAmerica  Nicole A Garcia,2011. Banks, Securities and the Volcker Rule: Background and Issues (Financial Institutions and Services). Edition. Nova Science Pub Inc. Hoffinger, David , 2009. U.S. Bank Stocks and the Subprime Crisis. 1st ed. New York: GRIN Verlag Rebonato, Riccardo , 2002. Modern Pricing of Interest-Rate Derivatives: The LIBOR Market Model and Beyond. 1st ed. Princeton: Princeton University Press. Miller-Jones, Edward R. , 2012. The Libor Scandal: Who are the Parties Concerned?. 1st ed. New York: FastBook Publishing. Read More