By Rahul Verma
The London Interbank Offer Rate (LIBOR) is the rate at which banks are willing to lend to other banks on unsecured terms. It is the reference and benchmark rate for global financial transactions, in debt and derivative markets, worth more than USD 260 trillion. Since its publication began in 1986, LIBOR which is quoted in five currencies (US Dollar, Pound Sterling, Euro, Swiss Franc and Japanese Yen) and for seven maturities (ranging from overnight to 12 months) has served as the reference rate for floating rate transactions be it swaps, loans or bonds. Its widespread use is evidenced by the fact that even consumer loans such as mortgages, auto loans and credit cards are linked to it.
LIBOR is calculated every morning by taking out an average of the inter-bank lending rates quoted by a group of banks. As the quotes are taken from a limited number of banks and averaged out, LIBOR is not truly representative of the entire market. Though its lack of representativeness did not limit its ubiquitousness in the financial world, it became a reason for its demise. LIBOR by virtue of its method of calculation is prone to manipulation. In 2012, the LIBOR rigging scandal came to light. Financial giants like Deutsche, HSBC, JP Morgan, Bank of America, RB, Barclays, Citigroup, Credit Suisse, BTMU were caught on the wrong foot. These banks among others quoted their inter-bank lending rates to benefit their traders. The malpractice had continued for years before the scandal surfaced. The collusion by the banks led the Financial Conduct Authority(FCA) to pass on the reins of LIBOR from British Banker’s Association to Intercontinental Exchange. However, the FCA made its stance clear that it will only support LIBOR till 2021 and LIBOR is due to be discontinued in 2021.
Although, the movement away from LIBOR to alternative rates has been at a reasonable pace in derivative markets and bond markets, loan markets have been slow to respond. LIBOR as a reference rate is commonly used to lend to non-financial corporates. The uncertainty regarding the alternative course of action in loan markets is a potential risk for businesses. Contracts worth trillions of dollars face uncertainty. It is only natural that businesses having existing contracts with tenors longer than 2021 are getting nervous. Another risk posed by LIBOR discontinuation is asset-liability mismatch for banks. LIBOR based lending meant banks had the same reference rate for borrowing and lending offering them a natural hedge. Any alternative would bring with it the risk of a double whammy for banks in case of stressful situations – borrowing costs increasing at a time when lending rates decrease.
The most obvious alternative is switching to Risk Free Rates (RFRs) as Reference Rates. RFRs such as SONIA (Sterling Overnight Index Average), SOFR (Secured Overnight Financing Rate), SARON (Swiss Average Rate Overnight) etc. are overnight rates in contrast to the forward-looking LIBOR rates. While the move to RFRs would bring in uncertainty regarding the interest payouts for corporates, they also offer an opportunity for the corporates to stop paying the credit risk premium for a non-representative segment of the market, a risk premium which was built into the LIBOR. This was especially problematic since the interest costs for the corporates could have gone up even if the central bank policy rates had moved downwards, if the credit risk premium for banks had increased. Another advantage that RFRs offer is daily compounding akin to the usual practice in derivative markets. Daily compounding would smoothen the interest rates reducing the possibility of any sudden change in interest rates that may be caused by market forces on any particular day in case of benchmark rates.
The discontinuation of LIBOR no matter how justified would leave a void in its wake. A void which is going to be extremely difficult to plug. Businesses should be aware of their existing exposure to LIBOR referenced contracts due to expire after 2021 and the fallback mechanisms available in those contracts. It is also imperative that they initiate talks with their counter-parties and have an amendment plan ready to mobilize as soon as alternative rates are available. Any new contracts should be drafted with language that would ease the transition clearly stating the costs and their bearer in case of amendments.
Rahul Verma is a business analyst at Vistas News