When LIBOR becomes LIEBOR: Reputational penalties and bank contagion

• Published date: 01 February 2021
• Author: Antonio Parbonetti,Xing Huan,Michele Fabrizi
• Date: 01 February 2021
• DOI: http://doi.org/10.1111/fire.12240

DOI: 10.1111/fire.12240

ORIGINAL ARTICLE

When LIBOR becomes LIEBOR: Reputational

penalties and bank contagion

Michele Fabrizi1Xing Huan2Antonio Parbonetti1

1Department of Economics & Management,

University of Padova,Italy

2WarwickBusiness School, University of

Warwick,United Kingdom

Correspondence

XingHuan, Warwick Business School, Univer-

sityof Warwick, United Kingdom.

Email:xing.huan@wbs.ac.uk

Abstract

We study whether commonality of incentives and oppor-

tunity to commit fraud trigger reputational contagion from

culpable firms to nonculpable firms. Relying on a sample of

30 banks involved in fixing the London Interbank Offered

Rate (LIBOR) and a control sample of 30 banks, we find that

banks’ reputations suffered substantial damage upon the

announcement of their involvement in the scandal. We also

document reputational contagion spread from banks that

manipulated LIBOR to banks that shared the same incen-

tives and opportunity to commit the fraud. The reputational

contagion is more pronounced for large derivatives dealers

who have had the strongest incentive to commit the fraud.

KEYWORDS

bank contagion, fraud triangle, operational risk, reputational

penalties

JEL CLASSIFICATIONS

G14, M41

1INTRODUCTION

Reputation plays an important role in modern corporate life as a quality-assuring device (Klein & Leffler,1981), and

the growing integration of the international financial market has created multiple channels for the transmission of

shocks. This paper addresses the reputational penalties that banks received for involvement in the LondonInterbank

Offered Rate (LIBOR) scandal and the contagion effect on other banks in the LIBOR and connected panels (“LIBOR

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and repro-

duction in any medium, providedthe original work is properly cited.

© 2020 The Authors. The Financial Review published by WileyPeriodicals LLC on behalf of Eastern Finance Association

Financial Review. 2021;56:157–178. wileyonlinelibrary.com/journal/fire 157

158 FABR IZI ET AL.

banks” hereafter). Extant literatureon the spillover effect of through-interorganizational networks, particularly direc-

tor interlocks, where the directors of firms sit on each other’s boards (Kang, 2008), and through the mechanism of

generalization by which reputational penalties spill overto other firms (Jonsson, Greve, & Fujiwara-Greve, 2009).

This paper examines the mechanisms through which contagion can be channeled and reputational penalties can

spill over from culpable firms to nonculpable firms. Specifically,we argue that reputational penalties spread from the

firm accused of misconduct to other firms that share with it the same incentive and opportunity to commit the fraud.

Rationalization, the incentive to commit a fraud, and the opportunity to do so are the three elements of the so-called

“fraudtriangle” developed by Cressey (1973) and used by Certified Public Accountants (CPAs)who seek to understand

and manage fraud risk. Commonality of incentivesand the opportunity to commit a fraudulent act represent a channel

through which generalization and contagion can spread from one firm to other nonaffiliated firms and is the channel

investigated in this paper.

The recent high-profile LIBOR scandal that centered on Barclays, Royal Bank of Scotland (RBS), UBS, and a num-

ber of other leading global banks has drawn considerable attention. While the damage from the scandal is still being

calculated, the LIBOR scandal’s setting offers the opportunity to appraise the penalties imposed by the markets and

the degree to which bank misconduct can affect other banks. Specifically, the contemporaneous presence of banks

accused of LIBOR manipulation and nonaccused banks that sit on the LIBOR panel provides us with a research set-

ting that allows us to test whether commonality of incentives and opportunity to misbehave trigger reputational

contagion.

We analyze the security returns of banks that are involved in LIBOR rigging during the period from March 2011

to December 2013 and identify 39 event dates on which banks are accused of or sanctioned for manipulating LIBOR.

Relying on a sample of 30 banks involved in fixing the LIBOR and a control sample of 30 banks, we find substantial

reputational damage, measured by the banks’ stock returns in a 3-daywindow around the event (i.e., [–1, +1]). We also

document a contagion effect of the reputational damage that is passed from banks accused of LIBOR manipulation

to nonaccused banks that share the same incentives and opportunity to commit the fraudulent act. We also show

that the contagion effect is significantly stronger among banks that are large derivatives dealers who have had the

strongest incentives to misbehave. Even when they were not accused of misconduct, they had experiencedstronger

repulational penalties.

Our paper contributes to the literature in several ways. The LIBOR scandal is in effect an operational risk event

that affected multiple banks (McConnell, 2013). Our paper pertains to the literature considering impacts of opera-

tional risk events on bank reputation measured by stock returns (Cummins, Lewis, & Wei, 2006; Fiordelisi, Soana &

Schwizer, 2014; Gillet, Hubner,& Plunus, 2010; Perry & de Fontnouvelle, 2005; Sturm, 2013). Our first contribution

is methodological. While most event studies focus on accused firms, we distinguish between nonaccused banks that

could manipulate LIBOR and those that could not. This unique feature of our setting allows us to investigatethe conta-

gion effect in a novel and unexploredperspective. Second, our paper contributes to the literature on the LIBOR scan-

dal. Extant literatureon the LIBOR scandal focuses on submission banks’ reporting behavior of the LIBOR rates during

the crisis period (Monticini & Thornton, 2013), and incentives for manipulating LIBOR (Gandhi, Golez, Jackwerth, &

Plazzi, 2019; Snider & Youle, 2014; Vaughan& Finch, 2017). Our paper complements these studies by showing how

markets react to the disclosure of banks’ fraudulent act and distinguishing banks with stronger incentivesto manipu-

late the LIBOR from those with weaker incentives.Third, our paper contributes to the literature on bank contagion by

documenting a new channel, represented by commonality of incentives and opportunity to commit the fraud,through

which contagion is channeled from culpable firms to nonculpable firms.

Findings in this paper on the reputational effect and contagion effect of the LIBOR scandal could also be of interest

to policy makers. The breadth of the contagion effect in the international banking system shown in this paper rein-

forces the importance of cross-country banking supervision and risk management.

The remainder of this paper is structured as follows: Section 2provides an overview of LIBOR and the LIBOR scan-

dal. Section 3reviews the related literature and develops the research hypotheses. Section 4describes the data and

methodology.Section 5presents the results. Section 6concludes.