Bankers without ethics

Tchaikovsky’s “1812 Overture,” which he wrote to commemorate Russia’s defense against Napoleon’s invading Grande Armée, is no match for prosecutors’ and regulators’ cannon fire lodged against banks and bankers some 200 years later. Case in point: the Swiss UBS. In November of 2012, the bank agreed to pay a record 1.4 billion Swiss francs or US$1.5 billion to U.S., U.K. and Swiss regulators to settle allegations in what has been described as a “pervasive” and “epic” plot to rig worldwide interest rates tied to trillions of dollars in loans and financial products. (See the Dec. 19, 2012, Financial Times article, “UBS pays price for ‘epic’ Libor scandal,” by Kara Scannell, Brooke Masters, Carolin Binham and Tom Burgis.)   

The amount of the regulatory fines levied on UBS for rigging the London InterBank Offered Rate (Libor, see sidebar at end of article) could be a small percentage of the total payments it and other banks may face in private civil litigation. (See “UBS Admits Rigging Rates in ‘Epic’ Plot,” The Wall Street Journal, Dec. 20, 2012, by David Enrich and Jean Eaglesham.) The reporters wrote that “Fannie Mae and Freddie Mac, the two U.S. mortgage giants, might have lost more than $3 billion as a result of banks’ alleged Libor manipulation.” (Libor is the average interest rate estimated by leading London banks that they would be charged if borrowing from other banks.) 

Plaintiff’s counsel will find a treasure trove of emails and other assorted communication between and among traders and brokers in the documents released in connection with the UBS settlement.  

According to the Financial Times article, “The Swiss bank’s Japanese arm pleaded guilty to criminal wire fraud” that the UK Financial Services Authority released findings that between 2005 and 2010 control failures and “the widespread and routine nature” of UBS traders attempts to manipulate Libor and Euribor rates (in Europe) meant that “every Libor and Euribor submission in currencies and tenors in which UBS traded is at risk of having been improperly influenced,” wrote the reporters. 

On Nov. 20, 2012, The Wall Street Journal reported that UBS ex-trader Kweku Adoboli was found guilty of fraud and sentenced to seven years in prison for his involvement in a $2.3 billion trading loss within the equity-trading desks at the Swiss bank’s London office. The prosecution described Kweku as a rogue trader who incurred losses and then tried to “win it back” with more unauthorized trades. The Wall Street Journal reported that in his own defense Kweku admitted to “circumventing UBS’s rules but insisted it was common practice at the firm and that he got in trouble only because he lost money.” (See “Former UBS Trader Adoboli Is Jailed for Seven Years,” by Dana Cimilluca, Vivek Ahuja and Richard Partington.) 

Although we’re not sure yet if violating trading limits at UBS and recording fictitious entries to cover unauthorized trades is common practice at UBS, the Swiss bank agreed to pay $47.5 million in penalties to British authorities in connection with the trading losses. The U.S. Financial Services Authority (FSA) and the Swiss Financial Market Supervisory Authority (FINMA) determined that UBS had exhibited deficiencies in risk management and internal controls. Paying fines for lack of adequate controls at the Swiss bank will add to the legal arguments on behalf of plaintiffs in what is certain to be a treasure trove of civil suits. (See “UBS Fined $47.5 Million in Rogue Trading Scandal,” by Mark Scott, DealBook in The New York Times, Nov. 26, 2012.) 

UBS was not the only bank caught in the web of deception in rigging interest rates. You might recall in June of 2012 Barclays settled with regulators for $450 million for its involvement in the Libor scandal. (See “Barclays Settles Regulators’ Claims Over Manipulation of Key Rates,” by Ben Protess and Mark Scott, June 27, 2012, The New York Times.)  

The New York Times reported that “regulators in the United States have issued subpoenas to several banks — including Bank of America, UBS and Citigroup — to understand how Libor was set. The Competition Bureau of Canada is investigating the activities of JPMorgan, Duetsche Bank and several other major banks.”

BEYOND LIBOR — MORE TROUBLES  

The Libor scandal was not the only bad news for banks in 2012. Bank of America (BofA) was hit with a $1 billion suit over home loans. The U.S. Department of Justice said that because BofA purchased Countrywide in 2008 it was liable for the so-called “hustle” and “high-speed swim lane” tactic of processing loans. (See “US sues BofA for $1bn over home loans,” by Tom Braithwaite, The Financial Times.) It would appear that in the loan business quantity trumped quality. The Securities and Exchange Commission (SEC) and other regulatory agencies are investigating Regions Financial Corp. for improperly classifying loans that went bad during the financial crisis. (See “Regions Financial bad loans probe widens-WSJ.”)  

On Dec. 11, 2012, Reuters reported that another British bank, HSBC, acknowledged that it transferred money for Mexican drug cartels and for countries that are under international sanctions, such as Iran. HSBC agreed to pay $1.9 billion to settle money laundering claims brought by U.S. regulators. (See "HSBC to pay record $1.9 billion U.S. fine in money laundering case,” by Carrick Mollenkamp and Brett Wolf.)  

In December of 2012, Morgan Stanley paid $5 million to the state of Massachusetts “to settle allegations that one of its highest-profile investment bankers tried to ‘improperly influence’ research analysts days before Facebook Inc. went public in May,” according to “Morgan Stanley Gets Facebook Fine,” by Aaron Lucchetti and Jean Eaglesham. According to the article, Facebook’s discussions about declining revenues with the investment banks’ research analysts prior to the company’s initial public offering “were relayed to the banks’ large clients but not small investors.” The offering price of $38 for Facebook fell to $20 shortly after the IPO.  

Morgan Stanley’s settlement with Massachusetts regulators isn’t the end of the Facebook fallout for Morgan Stanley. The SEC and Financial Industry Regulatory Authority are both continuing to investigate the circumstances surrounding Facebook’s IPO.

BANKERS NOT OFF THE HOOK 

Individual bankers (not just their employers) aren’t immune to regulators’ watchful eyes. According to the Dec. 19, 2012, Financial Times article, “UBS pays price for ‘epic’ Libor scandal,” the U.S. Justice Department criminally charged Tom Hayes (former Tokyo-based trader at both UBS and Citigroup) and Roger Darwin (Switzerland-based trader who was responsible for making and supervising UBS’s submissions to the Libor process) with conspiring to manipulate yen Libor rates to benefit trading positions. Hayes was also charged with “wire fraud, and antitrust violations for allegedly colluding with individuals at other banks.”  

Three days earlier the Financial Times, in the article, “Dozens to be implicated in UBS Libor deal,” by Kara Scannell and Brooke Masters, reported that ongoing investigations will continue and “about three dozen bankers and senior managers will be implicated in the alleged rigging of Libor interest rates when UBS settles with global regulators. …”  

On Dec. 28, 2012, Larus Welding, the former CEO of Glitner, the third-largest bank in Iceland before it collapsed in 2008, became the first bank executive to be convicted for crimes related in part to the financial crisis. Icelandic courts sentenced Welding to nine months in prison for fraud although six months of the sentence would be suspended for two years. (See “Ex-Iceland bank chief convicted of fraud,” by Richard Milne and Josephine Cumbo, Financial Times.) Welding’s penalty gives new meaning to the term light sentence.  

Why are so many banks cavalier? Why are many bankers willing to disregard the health of clients and shareholders for the sake of profit whether it be the dollar, euro, pound, yen or any other currency? Perhaps the open resignation letter penned by Greg Smith, former Goldman Sachs executive director and head of the firm’s U.S. equity derivatives business in Europe, the Middle East and Africa, published on the March 14, 2012, op-ed page of The New York Times, provides clues to the causes of bad bank culture and bad banker behavior in 2012.  

“To put the problem in the simplest terms, the interests of the client continue to be sidelined in the way the firm operates and thinks about making money. … [C]ulture was always a vital part of Goldman Sachs’s success. It revolved around teamwork, integrity, a spirit of humility, and always doing right by our clients. The culture was the secret sauce that made this place great and allowed us to earn our clients’ trust for 143 years. It wasn’t just about making money. … It had something to do with pride and belief in the organization. I am sad to say that I look around today and see virtually no trace of the culture that made me love working for this firm for many years. I no longer have the pride, or the belief.”  

Smith wrote that the decline in Goldman Sach’s “moral fiber” will be the “single most serious threat” on the survivability of the firm. He wrote the letter about just one bank. However, it appears that his words can now be applied to several banks. The current common thread is money earned, bonuses generated and investors neglected.  

The Libor probe into rate rigging was the most global of the fraudulent activities investigated by regulators in 2012. What started out as an investigation by two staffers in the U.S. Commodity Futures Trading Commission expanded to three continents — North America, Europe and Asia — with at least 10 regulators and prosecutors in Brussels, Canada, Germany, Japan, Switzerland and the U.K., in addition to the U.S. This scandal will just keep on giving in financial fines for years to come. 

You might recall an overture for “Hamlet” among Tchaikovsky’s numerous compositions. In Shakespeare’s play, Act I, Scene 3, Old Polonius counsels his son Laertes:  

“Neither a borrower nor a lender be,
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.” 

If Shakespeare were writing “Hamlet” in 2012, then perhaps those three lines would read: 

“Neither a lender nor a trader be,
For mortgage or rogue trade oft toxic thee,
And rigging rates ends all
integrity.”

Richard Hurley, Ph.D., J.D., CFE, CPA, is a professor at the University of Connecticut (Stamford) School of Business. 

Tim Harvey, CFE, JP, is director of the ACFE’s UK Operations and a member of Transparency International and the British Society of Criminology.  

Sidebar: 

Fixing the Libor 

By Tim Harvey, CFE, JP 

The artificial fixing of the London InterBank Offering Rate (Libor) has dramatic consequences both on U.K. financial services and the global banking fraternity. Of equal importance is the European Inter Bank Offering Rate (Euribor), which the European Banking Federation (EBF) publishes. The allegations go back some years and attempts to manipulate the rate appear to have started in 2005. (See “Fixing LIBOR: some preliminary findings,” House of Commons Treasury Committee.)

What is the Libor, and why is it so important?
Every day at 11 a.m. the British Bankers Association (BBA) publishes interest rates, which “set” the Libor. This rate won’t change until the following day; in the uncertain world of finance the Libor is a reliable and undisputed benchmark. The Libor is the rate at which banks lend money to each other, but it’s also used to determine payments made both on over-the-counter (OTC) interest rate derivatives contracts and exchange-traded interest rate contracts. The Libor also determines the rate of many other contracts including loans and mortgages. The integrity of such a rate is fundamental to the U.K. and international financial markets.

How is the rate set?
Historically, the BBA has calculated the Libor as averages from submissions made by a number of banks selected by the BBA or EBF. Since January 2010, BBA LIBOR Ltd, which is advised by the Foreign Exchange and Money Markets Committee (FX+MM), has set the Libor. 

The U.K.’s House of Commons Select Committee report states that until February 2011 the U.S. dollar Libor panel consisted of 16 banks. The rate calculation for each maturity excluded the highest and lowest four submissions, and an average of the remaining eight submissions was taken to set the published Libor. The Euribor operated a similar system with 40 selected banks. 

You can quickly see the effect any artificial movement would have on this benchmark rate. Even a movement of one basis point — .01 percent — could substantially increase traders’ profits or decrease losses. 

Agencies are still investigating allegations that many banks, including those outside Europe, attempted to manipulate the rate. According to “Fixing LIBOR: some preliminary findings,” from the House of Commons Treasury Committee, the Financial Service Authority (FSA, the U.K.’s financial regulator) found that Barclays Bank misconduct included “making submissions which formed part of the LIBOR and EURIBOR setting process that took into account requests from Barclays’ interest rate derivatives traders. These traders were motivated by profit and sought to benefit Barclays’ trading positions; seeking to influence the EURIBOR submissions of other banks contributing to the rate setting process; and reducing its LIBOR submissions during the financial crisis as a result of senior management’s concerns over negative media comment.” 

The FSA also found that Barclays failed to have adequate procedures and controls in place relating to its Libor and Euribor submissions. The House of Commons Treasury Committee was also concerned that the FSA was two years behind U.S. regulatory authorities in initiating its formal Libor investigations. 

The Lord Chancellor of the Exchequer (the government department responsible for management and collection of taxation and other revenues) has asked the chief executive of the Financial Conduct Authority to review possible reforms to the current framework for setting the Libor. 

The FSA in its June 27, 2012, final report highlighted how individual derivative traders stood to gain or lose by manipulation of the rate. Financial institutions use interest rate derivatives contracts to manage their interest rate risks and can make significant profits or incur losses by entering into interest rate derivatives contracts.  

Simple OTC interest rate swaps consist of an agreement between two parties to pay each other interest on a speculative amount at specified rates and dates. An interest rate swap will involve two payment obligations; one party will pay interest at a fixed rate, and the other party will pay interest at a variable (or floating) rate at specified points over the term of the swap. The floating part of this agreement may relate to the Libor or Eurobor over a three-, six-, nine-month or yearly period. The traders would make their requests to “submitters” at banks who’d be responsible for entering the submission.  

According to the FSA final report, what is perhaps alarming is that the traders would ask submitters to put submissions in high or low — depending on their deals. The traders were also aware of the effect of having their submissions knocked out for being too high or low. Banks tolerated this unreported behavior as part of trading-room culture. 

Clearly, new processes and procedures must prevent banks from manipulating the Libor. The overwhelming lesson from this debacle is that banks must set the tone at the top at the highest standard. No matter the size of an institution, it has to review its practices and operating procedures to maintain acceptable trading.