LIBOR: Beyond a Simple Number FIN3560: Financial Markets and Instruments
“I pledge my honor that I neither received nor provided any unauthorized assistance during the completion of this work.”
“The authors of this paper hereby give permission to Professor Michael Goldstein to distribute this paper by hard Ben Simon copy, to put it on reserve at Horn Library at Babson College, or to post a PDF version of this paper on the internet.” Han Kim
Mario Sulev
Jack Laboz
12/3/2012 Page | 1
Table of Contents
Executive Summary ……………………………………………………………………………. 2 Introduction of LIBOR ………………………………………………………………………… 3 History …………………………………………………………………………………………. 3 LIBOR and its Impact on the FTSE 100 ………………………………………………………. 4 LIBOR’s Connection to Global Financial Assets ……………………………………………... 6 LIBOR Scandal ………………………………………………………………………………... 8 Incentives to Rig the LIBOR …………………………………………………………………... 8 Regression Analyses …………………………………………………………………………... 9 Future of LIBOR ………………………………………………………………………………. 11 Conclusion ……………………………………………………………………………………... 13 Regression Exhibits ……………………………………………………………………………. 15 Paper Exhibits ………………………………………………………………………………….. 18 References ……………………………………………………………………………………… 22
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Executive Summary
In examining and analyzing the London InterBanking Rate, LIBOR, we have concentrated on the history, its impact on the FTSE 100, their connection to global financial assets, and the recent LIBOR rate adjusting scandal. The main history of the rates shows us that this tremendously important global rate has been subject to major variance over its relatively short life cycle thus far. We have found that this fluctuation is a result of both changes in the economy such as reflected by the FTSE 100 as well as the macroeconomic conditions. The variation in LIBOR is exceptionally substantial to the global financial assets as it is the most widely used baseline rate for lending between banks. Due to the nature of the financial process and the nature of lending, the trickle-down effect comes into play with the LIBOR rates making it that an estimated $800 trillion in investments is influenced by their rates. One the most recent stories to shake the financial world is the LIBOR scandal where it has been found that the LIBOR rates have been deliberately altered by some of the largest financial institutions in the world. With such a globally significant rate tied to the world’s economy this particular scandal shows the results of greed and the true disregard for others. To further examine the importance of the LIBOR rates and how they played a role in the scandal we chose to statistically analyze the relationship between the 3-month LIBOR rates and the Barclay’s stock price. This was performed to determine how the changes in rates affected the overall value of the company as reflected in its share price. We also investigated the effects of changes in LIBOR rates on the actual mortgage rates. This was chosen to contrast the effects on the corporate world as done with our first regression by looking at something that would more directly affect the average person. Our findings have shown the overall significance of LIBOR to be globally overwhelming. With our regression analysis we have found the rates to have some influence on both large corporations and in turn on the average person. We came into this project knowing very little on the subject but now with our newly acquired knowledge we want to educate others on the subject to stress the importance of this truly important rate.
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Introduction of LIBOR The London Interbank Offered Rate, commonly known as LIBOR is a benchmark interest rate that is used for banks to borrow funds from other banks. The actual rate is derived from an adjusted average of 20 of the world’s top creditworthy banks interbank deposit rates. The rate is then given in varied maturities ranging from overnight to one full year1. The official private company used as the calculation and distribution agent is Thompson Reuters under the auspices of the British Bankers Association (BBA). The actual rates are announced daily by Thompson Routers at 11:45 a.m. and are published by partners of the British Banking Association2. The LIBOR is the most widely used benchmark for short-term interest rates. Since LIBOR is the rate at which banks can borrow money it is also the rate at which large corporations look at to reference where they might be able to borrow at. 3
The History The London InterBank Offered rate first published in January 1986 was created as a response to the increased trading of options on the basis of loans. Due to this, there appeared a new need to evaluate what a bank should charge for a loan in the future based on the current markets.4 The real need was for various parties to be able to negotiate a contact based on what an interest rate would be in the future. In 1984 the British Banking Association created a panel of banks to report what their rates for various loan rates and various currencies. “This poll would be used by all banks to price derivatives. In fact, the actual question posed was: "At what rate do you think interbank term deposits will be offered by one prime bank to another prime bank for a reasonable market size today at 11am? “ (USE Economy). Then in 1985 the same association, BBA, began to publish what would eventually become the LIBOR, the BBAIRS. Then in January of 1986 the first LIBOR rate was published as three currencies (British sterling, Japanese Yen and U.S. Dollar). The modern LIBOR rate is published in ten currencies (AUD, CAD, CHF, DKK, EUR, GBP, JPY, NZD, SEK, USD) and is presented in fifteen maturity period lengths from one day to one year5. .When looking at historical data of the LIBOR rates it is apparent that there are district peaks and valleys in its history of the actual rates themselves (refer to exhibit A.). In the very beginning of the
1 From http://www.investopedia.com/terms/l/libor.asp#axzz2DqCvqF74 2 From http://www.global-rates.com/interest-rates/libor/libor-information.aspx 3 From http://thomsonreuters.com/content/news_ideas/articles/financial/our-role-in-the-calculation-and- distribution-of-libor 4 See http://www.bbalibor.com/ Information used from the introduction page as well as rates and panels pages. 5 From http://useconomy.about.com/od/monetarypolicy/a/history_LIBOR.htm
Page | 4 history of LIBOR between 1989-1990 the rates were the highest they have ever been. In the immediate years following these historically high rates there was a dramatic decline until mid-1994 where it rose fairly rapidly. One of the most dramatic declines happens around the release and implementation of the Euro in the early 2000’s where it declined for a little over 4 years. After the financial crisis of 2008 the rates rapidly declined to their current all-time low status. For example for the past 3 years the 1-month LIBOR rate hasn’t even crossed the .5% mark which is an extremely far cry from the 9% rates in February of 1991.6 Although there is some fluctuation between the 1 month, 3 month, 6 month and 12 month LIBOR rates, in general over time they follow very similar patterns. The variance between the rates for the different time lengths is the greatest when rates drop to there lowest such as between 2001-2002 and the rates from 2009 to the present. This is however a simple result of the mathematical properties of the rates themselves. Due to the fact that the rates are so low, it appears as though the differences between the time lengths in terms of rates are fairly substantial. For example the 12-month rate is roughly 4 times higher than the 1-month rate (.25% compared to 1%), however the actual spread as a number is not much different than in other years. In November of 1999 the 1-month rate was around 6.6% and the 12-month rate was around 7.4%, which is a spread of .8%, very comparable to the current .75% spread.6
LIBOR and its Impact on the FTSE 100 The ultimate outcomes of monetary policy are usually defined by macroeconomic variables such as GDP, unemployment rates and inflation. Although the goal of policy makers is to control the aforementioned variables by open market operations, more often than not their policies have drastic impacts on financial markets. Monetary policies will affect an assets price and return, thereby having a significant impact on the stock market.7 Not surprisingly, financial analysts pay extra careful attention to the impact that changes in monetary policy, such as LIBOR, have on financial markets. In this analysis of how changes in LIBOR impacts financial markets, London’s share index- the FTSE 100 will be used as a comparative model. FTSE 100 (Exhibit C) index is designed to review the performance of UK companies in the London Stock Exchange. With a few exceptions the FTSE 100 is an index comprised of the 100 largest companies listed on the London Stock Exchange. Similarly to Nasdaq, S&P 500 or Dow Jones to the US, the index is seen traditionally as a good indication of the performance of major companies listed in the UK. In his essay “Monetary Policy Shocks and Stock Returns: Evidence from the British Market,” economist Andros Gregorio examines the impact of both anticipated and unanticipated policy changes of
6 From http://www.fedprimerate.com/libor/libor_rates_history-chart-graph.htm 7 From http://www.gla.ac.uk/media/media_22185_en.pdf Page | 5 the Bank of England Monetary Policy Committee (MPC) on the FTSE 100. He utilizes the change in the three-month sterling LIBOR from futures contract, from June 1999 to March 2009, to calculate monetary policy shock. By using time-series and regression models he finds that stock returns are significantly impacted by expected and unexpected monetary changes. From his research he finds that “during normal times stock market response to both expected and unexpected interest rate changes is negative and significant.” However, he notices a fundamental break in stock market prices in reaction to unexpected monetary policy caused by crises such as the Dotcom bubble burst of 2000 and the credit crunch of 2007- 2008. He explains: “Our results document an important structural break in the stock market reaction to monetary policy changes since the onset of the credit crisis. While before the crisis the stock market responds negatively to higher interest rates, the stock returns-interest rate change relationship becomes positive during the credit crunch. The latter finding indicates that, so far, highly expansionary monetary policy has not been able to reverse the negative trend in stock prices highlighting the severity of the ongoing crisis.”8 However, Gregorio is not the only economist who has studied this trend. Don Bredin has written an essay “UK Stock Returns and the Impact of Domestic Monetary Policy Shocks,” in which he attempts to dig deeper into the relationship between LIBOR rates and the FTSE. His findings on the aggregate level are in accordance to that of Gregorio. He says: “At an aggregate level, the surprise element in UK policy rate changes gives rise to a negative significant effect on FTSE returns…Quantitatively, the results imply that a surprise 25 basis point increase in the UK policy rate is associated with roughly a 0.2 percent decline in the FTSE return.” This does not appear to be news to anyone as this is just a mere summary of Gregorio’s findings that changes in LIBOR have a negative effect on the FTSE. But Bredin investigates further; he wants to find an underlying cause for this negative relationship. To do so he examines stock prices on a sectorial level. Nearly all sectors appear to have a significant negative response to a surprise change in monetary policy. The sectors where the most significant negative response in terms of future returns are found to include auto parts, chemicals, engineering, oil and gas, retail, and steel (Exhibit B). These sectors of the economy are of the most capital-intensive industries, where external borrowing and debt levels are typically an issue, and are therefore especially prone to changes in interest rates such as LIBOR.9 The results of the analysis are uniform; both parties would agree that the FTSE 100 has a negative change when there is a surprise shock in LIBOR rates. In March of 2004 current Federal Reserve chairman Ben Bernanke did a similar study where he attempted to find a the affects of Federal Reserve policy on the stock market. In his analysis he uses the Federal Funds Rate as the variable for Fed policy.
8 From http://www.gla.ac.uk/media/media_22185_en.pdf 9 From http://irserver.ucd.ie/bitstream/handle/10197/1167/WP-06-04.pdf?sequence=1 Page | 6
His results were quite similar to the effect that LIBOR has had on the FTSE 100. With an anticipated change in the Federal Funds Rate there would be a 1.11 decrease in CRSP rating, while with unanticipated change there would be an astonishing 11.43 decrease in CRSP.10 Bernanke does not see the relationship between stock prices and monetary policy as absolute but he does see it as significant. He states: “Stocks are claims to real assets, so if monetary neutrality holds stock values should be independent of monetary policy in the very long run. In the medium term, however, real and nominal volatility induced by the form of the monetary policy rule may well influence stock values.”11 As to why monetary policy has influence on stocks? The answer to this is more difficult. But he suggests “tight money lowers stock prices by raising the expected equity premium.” This could happen in two ways: “First, tight money could increase the riskiness of stocks directly, for example, by raising the interest costs or weakening the balance sheets of publicly owned firms.” “Second, tight money could reduce the willingness of stock investors to bear risk, for example by reducing expected levels of consumption…or because of its association with higher inflation.” What we do know is that unexpected changes in LIBOR usually will have a negative impact on stock market performance in the short-medium term; exactly why this happens remains unclear, but is something that should be evaluated more thoroughly.
LIBOR’s Connection to Global Financial Assets An estimated $800 trillion worth of investments are pegged to LIBOR12. To put that number in perspective, the world’s GDP is estimated to be less than $70 trillion—that’s over 10 times less than the amount of investments that are pegged to LIBOR.13 LIBOR has served as the primary baseline for interbank loans since its inception in 1986.14 However, its reach is far greater than the interest rate at which banks charge one another. Included in the $800 trillion worth of investments are at least $10 trillion dollars in loans and $350 trillion in swaps.15 Being that LIBOR is a basis point for a wide array of
10 The CRSP (Center for Research in Security Prices) database contains information on securities traded on the New York and American Stock Exchanges, and the NASDAQ system. Daily listings on prices, returns, and a number of other data points can be accessed from this data base as well as other useful information for issues traded on these exchanges. The data set also contains daily listings on market performance. http://www.unt.edu/rss/crsphist.htm 11 From http://www.federalreserve.gov/pubs/feds/2004/200416/200416pap.pdf 12 From http://online.wsj.com/article/SB10001424052702304299704577500982100334286.html 13 From Google Public Data, Gross Domestic Product- World 14 From http://www.clevelandfed.org/research/trends/2012/0712/01banfin.cfm 15 From http://www.nytimes.com/2012/07/07/opinion/libors-dirty-laundry.html. Page | 7 financial instruments, ranging from floating rate investments to securities to derivatives, these figures should not be seen as exorbitant. A derivative is literally “a substance that can made from another substance“— financial derivatives are based on the same principle 16. A derivative is a financial instrument that gets its value from some real good or stock. It is in its most basic form simply a contract between two parties to exchange value based on the action of a real good or service. Typically, the seller receives money in exchange for an agreement to purchase or sell some good or service at some specified future date.17 Many derivatives frequently involve assets that are tied to LIBOR, including forward and future contracts, options, and swaps. In a swap for example, there is usually an exchange in interest rates on loans between two companies, based on a specified principal amount. In many cases companies will exchange fixed interest rates for variable rates that are usually linked to LIBOR.18 As a result of LIBOR being a baseline for numerous derivatives, it is estimated that $$350 trillion worth of derivatives are linked to LIBOR.19 Inflation, among many things, can pose serious threats to an investor’s return. Investors aim to increase their purchasing power from a given investment. Yet they first must keep up with the rate of inflation in order to start increasing their purchasing power. In particular inflation poses the biggest threat on fixed income investments. The reason for this on most fixed rate investments interest rates will remain the same until maturity, so as inflation rises, the purchasing power of interest payments will decrease.20 In order to combat inflation risk floating rate securities or floaters can be used. Floaters are investments that offer interest payments that can increase or decrease depending on a specified rate, most commonly LIBOR. The use of floaters has increased drastically over the past 15 years. As of 2009 there were an estimated $531 billion worth of floating rate loans on the market—in 1997 there were only 35 (see table A for a graph that charts the growth of floating rate investments). 21 Floating rate investments are of the biggest instruments that are Floating rate investments and derivatives are only two of the many financial instruments that primarily use LIBOR to define interest rates. As was mentioned there are an estimated $800 trillion worth of investments pegged to LIBOR. It displays how important of a rate LIBOR is and merely demonstrates the possible effect of LIBOR manipulation on the financial world.
16 From http://www.cob.ohio-state.edu/fin/faculty/stulz/publishedpapers/milkeninstitute_pubpaper.pdf 17 From http://www.wisegeek.com/what-are-financial-derivatives.htm 18 From http://www.ehow.com/facts_6834503_libor-swap-definition.html 19 Nocera, Joe. "OP-ED COLUMNIST; Libor's Dirty Laundry." The New York Times. The New York Times, 07 July 2012. Web. 01 Dec. 2012. 20 From http://www.pimco.com/EN/Education/Pages/InflationPrimer.aspx. 21 From http://www.investmentnews.com/assets/docs/CI7092493.PDF Page | 8
LIBOR Scandal The rapidly unfolding headliners concerning the details of the LIBOR scandal have begun to capture worldwide attention as some critics believe it to be one of the biggest heist in the history of finance. There are growing evidences and documents citing misconduct by traders and banks for their attempts to manipulate and rig the LIBOR over the period of at least five years, starting as early as 2005. Since this rate is used to price hundreds of trillions of dollars worth of varying global financial instruments, meddling with such rate could have extraordinary implications. Robert Scheer, a renowned journalist with thirty years of experience described the scandal as a “reeking cesspool of unprecedented corruption”.22 Barclays, a major global financial service provider is under the spotlight for their major involvement in this scandal as they have already paid more than $450 million by British and American regulators. However, this does not mean that Barclays was the only bank involved in this scandal. There are 16 banks under the current LIBOR investigation, with big names ranging from Bank of America, Citigroup, JP Morgan and more.23
Incentives to Rig the LIBOR There are several motives and incentives as to why banks and traders might have wanted to manipulate the LIBOR. One major reason is that traders could increase profits or reduce losses on their derivative exposures by influencing the final LIBOR fixing. Barclays was a leading trader of these types of derivatives and with even a small movement in the final figure of LIBOR could have resulted in daily profits or losses equaling millions of dollars. For example, in 2007, the loss or gain that Barclays could make by moves in interest rates over any given day was $40 million.24 During the period between 2005 and 2007, traders from Barclays would communicate with other traders from different banks and urge them to submit rates that would benefit their derivatives trading positions. The following are emails exemplify how traders would ask LIBOR submitters to manipulate the interest rate: "Hi Guys, We got a big position in 3m libor for the next 3 days. Can we please keep the lib or fixing at 5.39 for the next few days. It would really help. We do not want it to fix any higher than that. Tks a lot." — Senior trader in New York to submitter sent on DEC. 14, 2006 “For Monday we are very long 3m cash here in NY and would like the setting to be set as low as possible ... thanks” — Trader in New York to submitter sent on JULY 29, 2007
22 Paraphrased from http://business.time.com/2012/07/09/libor-scandal-the-crime-of-the-century/ 23 From http://www.huffingtonpost.com/2012/07/11/libor-rate-scandal_n_1664737.html 24 From http://www.economist.com/node/21558281 Page | 9
“Pls go for 5.36 libor again, very important that the setting comes as high as possible ... thanks.” — Trader in New York to submitter 25 Evidence of this type of misconduct has been found to be prevalent globally, involving traders not only in New York and London but also Tokyo. According to a report by the Financial Services Authority, between January of 2005 and June 2009, derivative traders from Barclays have made 257 requests to fix the LIBOR.26 Another significant motive behind LIBOR manipulation was to disguise the banks’ financial stability, especially during the depths of the financial crisis after 2008. Bob Diamond, the former CEO of Barclays who resigned due to the scandal, admitted that Barclays and other banks submitted unrealistically low LIBOR rates. The purpose of such action was to paint a false image of stability to avoid market panic as well as avoiding additional government regulation.27 According to allegations presented in the legal complaint by the financial company Charles Schwab, UBS paid 2.85% in mid-April of 2008 to borrow dollars for three months yet on April 16th of 2008, UBS submitted 2.73% as its LIBOR reference.28 On average, almost all the banks in the LIBOR panels were sending rates to the BBA that were thirty to forty basis points too low. Especially for banks that were weak, they had no incentives to submit honest estimates of the high borrowing cost they actually had to pay.29 As the scandal continues to unfold, lawsuits in the United States continue to emerge. There are already twenty lawsuits that are seeking damages from banks that participated in the scandal.30 Plaintiffs include cities, pension funds, financial institutions and private investors. Some are going as far as suggesting that bankers should be jailed. According to a survey, an astounding ninety percent of people in the UK believe that LIBOR-rigging bankers should be jailed.31
Regression Analyses Barclays Regression Our first analysis presented examines the relationship between the stock prices (Exhibit D) of Barclay’s PLC (ADR) (NYSE;BCS) and the 3 month LIBOR rate. We specifically chose the time period of 2005-2007 based on the time frame used in the recent LIBOR scandal involving Barclay’s. Our
25 From http://www.nytimes.com/interactive/2012/07/10/business/dealbook/behind-the-libor-scandal.html 26 From http://www.bbc.co.uk/news/business-18671255 27 From http://www.washingtonpost.com/blogs/wonkblog/wp/2012/07/05/explainer-why-the-libor- scandal-is-a-bigger-deal-than-jpmorgan/ 28 From http://www.lieffcabraser.com/media/pnc/4/media.904.pdf 29 From http://www.economist.com/node/21558281 30 From http://www.spiegel.de/international/business/the-libor-scandal-could-cost-leading-global-banks- billions-a-847453.html 31 From http://www.telegraph.co.uk/finance/libor-scandal/9595611/Libor-rigging-bankers-should-be- jailed-survey-finds.html Page | 10 analysis looks into how the changing LIBOR rates may or may not have any significant influence on the Barclays stock price. We do realize that the stock price of any company is influence by many factors however we wanted to examine this rate in particular because it has such a dramatic effect in the financial sector and because Barclay’s may have actually benefitted from the fixing of LIBOR rates. For our model we compared the 3-month rate to the stock price of Barclay’s due to the fact that it is the most commonly used time length for the different rates. By studying this relationship we are examining the effective relationship between the value of their company and the offered rates, which gives insight as to how much they actually benefited from any fluctuations in the changing of rates. The following is the regression results from the Minitab software. The regression equation is Open = 24.3 + 5.03 3 Month Rate Predictor Coef SE Coef T P Constant 24.261 4.132 5.87 0.000 3 Month Rate 5.0272 0.8532 5.89 0.000 S = 4.59782 R-Sq = 50.5% R-Sq(adj) = 49.1%
P-Value Our regression analysis resulted in a p-value of 0.000, which suggests that the regression that the 3 month LIBOR variable is statistically significant enough to be considered. Although this does not necessarily indicate that there is a strong relationship between our two variables this does indicate that our regression is valid and open to interpretation. Best Fit (R-Squared) Our regression analysis output from Minitab shows our R-squared adjusted which in our case measures the percentage of the Barclay’s stock movement explained by the benchmark movements. This is a measurement similar to that of an R-squared measurement for fixed-income securities where the benchmark is the T-bill or for equities where the benchmark is the S&P 500. In our case the R-squared adjusted is 49.1%, which does not indicate a particularly high explanation of movements based on the benchmark. For example with equities it is typical for an R-squared of less than 70 to be considered a low indication based on the benchmark. For our example of 49.1% we can conclude that this regression model between Barclay’s stock prices and 3 month LIBOR rate is not significantly explained by the benchmark for the time period of 2005-2007. Mortgage Regression Our second analysis was to compare the 30-year fixed rate mortgages in the U.S. with the 3- month LIBOR to probe any possible relationship during the time period of 2005-2009. We wanted to see statistical verification on whether LIBOR rates had any relationship with how much interest homeowners were paying. For our model the first output provided several unusual results or statistical outliers. To Page | 11 improve our model to be more true to the average date we removed the statistical outliers, which significantly improved our model. The regression output from Minitab is as follows:
The regression equation is 30yr FRM = 4.98 + 0.295 3m LIBOR
Predictor Coef SE Coef T P Constant 4.9838 0.1001 49.77 0.000 3m LIBOR 0.29457 0.02480 11.88 0.000
S = 0.333522 R-Sq = 72.3% R-Sq(adj) = 71.8%
P-Value
Our model provided a p-value of 0.000, which shows that our model is statistically significant, and therefore a valid model to go by. In our model we removed some of the outlying data, which did not affect this p-value.
Best Fit (R-Squared)
For our model the R-squared adjusted is 71.8%, which is high enough to be considered a low indication. Although the category of a low indication may appear to be somewhat meaningless we must consider this R-squared adjusted and its role in the given application. Our model is an indication that the LIBOR rates influence the mortgage rates. The connection here is explained by the fact that banks borrow at the given LIBOR rates and then in turn can lend funds through mortgages based on these rates. Based on our statistical conclusions it is apparent that there are factors that influence the mortgage rates besides the LIBOR rates, which we cannot determine from our model. It is possible that these other factors could include the variations and seasonality of demand for mortgages and therefore the adjustments made by banks to try to combat these fluctuations in demand.
Future of LIBOR Martin Wheatley published a 92 page report outlining a 10 point plan for LIBOR overhaul on September 28th of 2012. The UK government accepted Wheatley’s recommendations shortly after the publication of the report and has begun pushing for legislative implementation. By implementing these recommendations, the government will try to restore the credibility of the benchmark and to prevent another manipulation from happening. The 10 point plan is divided into five categories:32
32 From http://www.guardian.co.uk/business/2012/sep/28/libor-review-key-points-wheatley-report Page | 12
Regulation of LIBOR: There has been talk by authorities that they should introduce statutory regulation of the administration of and the submission to LIBOR. This could include an Approved Persons regime, to assist in the assurance of reliable independent control, oversight and regulation for both civil and criminal.33
Institutional reform:
The BBA will no longer be the administrator and an open competition will be held to find the new administrator. “The new administrator should fulfill specific obligations as part of its governance and oversight of the rate, having due regard to transparency and fair and nondiscriminatory access to the benchmark.”33 The new administrator will be responsible for “compiling and distributing the rate, as well as providing credible internal governance and oversight”34 A likely new administrator is Thomson Reuters and they have admitted to considering this role.35
The rules governing LIBOR:36 The submitting banks should comply with the guidelines set in the report, by clearly using transaction data in order to back their submissions. A code of conduct should be introduced for the submitting banks. The code of conduct should include: Guidelines for using transaction data to determine submissions, systems and controls for the submitting firms, submitting banks would be required to keep transaction records, as well as regular external audit requirement. For the future, manipulation will be regarded as a criminal offense.37Moreover, managers who supervise the employees who make submissions to Libor will be approved by the FSA.38
Immediate improvements of LIBOR:
The number of LIBOR maturities and currencies will be decreased to the ones in which borrowing occurs. If there is not sufficient trade data for a particular currency/tenor LIBOR should not be computed and these rates must be removed. This will remove the guesswork from the banks.38The individual bank rates will not be published for 3 months. Currently they are published immediately which gives incentives
33 From http://www.bloomberg.com/news/2012-09-27/wheatley-s-review-draws-the-right-conclusions- about-libor.html 34 From http://cdn.hm-treasury.gov.uk/wheatley_review_libor_finalreport_280912.pdf 35 From http://thomsonreuters.com/content/news_ideas/articles/financial/our-role-in-the-calculation-and- distribution-of-libor 36 From http://cdn.hm-treasury.gov.uk/wheatley_review_libor_finalreport_280912.pdf 37 From http://www.bloomberg.com/news/2012-09-27/wheatley-s-review-draws-the-right-conclusions- about-libor.html 38 From http://www.guardian.co.uk/business/2012/sep/28/libor-review-key-points-wheatley-report Page | 13 to the banks to lower them in order to hide signs of financial instability.39In addition banks, even including those not currently submitting to LIBOR will be encouraged to participate as widely as possible in the LIBOR compilation process, including through new powers of regulatory compulsion.”37
International co-ordination: The UK authorities will collaborate closely with the European and international community in order to contribute fully to long-term future of LIBOR and other benchmarks. The authorities will establish and promote clear principles for effective global benchmarks.37In the end, the Wheatley Review of LIBOR sets clear and practical guidelines for LIBOR to be improved. We believe that these changes will take away the major incentives for manipulating the LIBOR and thus restore the reputation and usability of LIBOR.
Conclusion
The LIBOR is arguably the most important financial rate due to its connection to hundreds of trillions of dollars’ worth of global financial assets. However, the systematic process for calculating the LIBOR seems to be very subjective and generally flawed because of its tempting incentives for traders and banks to manipulate such rate for their own interests. The LIBOR scandal could go down in history as possibly the crime of the century. Our analysis on probing the possible relationship between Barclays’ stock prices during the relevant time period of the bank’s LIBOR rigging did not show enough statistical significance for us to conclude any concrete inferences. Something that might have had a stronger relationship could have been monthly interest revenue during 2005 to 2007 and the 3-month LIBOR. This is because before the credit crunch, historical LIBOR rates seem to have been artificially inflated, as the scandal unveiled, thus Barclays’ could influence the movements in the LIBOR in favor of their interest rate sensitive derivative positions and increase their interest revenue. However, because data on their monthly interest revenue is not available to us, we were not able to test the regression. Our second analysis showed decent statistical proof that homeowners were being affected by the LIBOR and the scandal. During times of artificially inflated LIBOR rates, mortgages were also higher, meaning that homeowners had to pay more simply because of the unethical greed of banks and traders. However, during times when banks were lowballing their LIBOR to hide financial instability and solvency issues, homeowners would save money on mortgages. However, at the same time, pension funds Page | 14 and other investors who put money in mortgages backed securities lost interest revenue that they could have had if the LIBOR was honestly submitted. In the end, the complete overhaul of LIBOR could to be the silver lining for general confidence in the banking and financial sector. However, after a heist like the LIBOR scandal, it may take a while before the general populace regains faith in the integrity and confidence in the morals and ethics of Wall Street and the heart of finance.
Regression Exhibits
Regression Analysis: Open versus 3 Month Rate
The regression equation is Open = 24.3 + 5.03 3 Month Rate
Predictor Coef SE Coef T P Constant 24.261 4.132 5.87 0.000 Page | 15
3 Month Rate 5.0272 0.8532 5.89 0.000
S = 4.59782 R-Sq = 50.5% R-Sq(adj) = 49.1%
Analysis of Variance
Source DF SS MS F P Regression 1 733.95 733.95 34.72 0.000 Residual Error 34 718.76 21.14 Total 35 1452.71
Unusual Observations
3 Month Obs Rate Open Fit SE Fit Residual St Resid 1 2.74 45.970 38.055 1.883 7.915 1.89 X
X denotes an observation whose X value gives it large leverage.
Time Series Plot of Open
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Time Series Plot of 3 Month Rate 6.5
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5.5 e t 5.0 a R h t 4.5 n o M
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Scatterplot of Open vs 3 Month Rate
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Regression Analysis: 30yr FRM versus 3m LIBOR
The regression equation is 30yr FRM = 4.52 + 0.375 3m LIBOR
Predictor Coef SE Coef T P Constant 4.5174 0.1919 23.54 0.000 3m LIBOR 0.37500 0.04000 9.37 0.000
S = 0.205078 R-Sq = 72.1% R-Sq(adj) = 71.3%
Analysis of Variance
Source DF SS MS F P Regression 1 3.6959 3.6959 87.88 0.000 Residual Error 34 1.4299 0.0421 Total 35 5.1259
Unusual Observations
Obs 3m LIBOR 30yr FRM Fit SE Fit Residual St Resid 1 2.74 5.7100 5.5464 0.0861 0.1636 0.88 X
X denotes an observation whose X value gives it large leverage.
Time Series Plot of 30yr FRM, 3m LIBOR
7 Variable 30yr FRM 3m LIBOR
6
a 5 t a D
4
3
4 8 12 16 20 24 28 32 36 Index
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Scatterplot of 30yr FRM vs 3m LIBOR 7.00
6.75
6.50 M R F
r 6.25 y 0 3 6.00
5.75
5.50 3.0 3.5 4.0 4.5 5.0 5.5 3m LIBOR
Paper Exhibits
Exhibit A.
Source: Fed Prime Rates, http://www.fedprimerate.com/libor/libor_rates_history-chart-graph.htm
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Exhibit B.
Notes: e y reflects news about current excess return, e ̃d is news about future dividends, e ̃r is news about real interest rates and e ̃y is news about future excess returns. The numbers in parenthesis contain t- statistics which use the bootstrap simulation (10,000 runs). The highlighted numbers express the significant negative response of British economy sectors to news regarding the changes in future excess returns. This data chart was taken from Don Bredin’s essay “UK Stock Returns and the Impact of Domestic Monetary Policy Shocks.”
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Exhibit C. Historic FTSE 100 Source: Historic FTSE 100 prices, Yahoo Finance
Historic 3-month LIBOR
http://www.bloomberg.com/quote/US0003M:IND/
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Exhibit D. Barclays stock prices 2005-2007 Source: Yahoo finance
http://finance.yahoo.com/charts?s=BCS#symbol=bcs;range=20050103,20071231;compare=;indicator= volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=undefined;
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