Imagine you’re a bank. You lend your customers money, it’s one of the ways you make your money. You want to lend money. Lending money comes with the territory.
Some would say it is your raison d’être, but sometimes you might not have enough cash on hand to dish out the funds you’re being asked for. You can’t lend more money than you have in your reserves, and there are very strict limits on how small you can allow your reserves to shrink to. What do you do? Well borrow some cash from another bank with a load to spare, of course! Great, but this won’t be free.
Lending money is one of the ways in which a bank makes its money, after all! So, an interest rate will need to be charged by the lending bank to the borrowing bank.
As you’re a bank and you’re like to return the favour at some stage, you’re likely to get a good rate from your compatriots. But this does depend on whether banks feel confident in the general financial strength of the money market.
The rates they charge to one another will be lower if they have confidence in other banks’ ability to repay these loans.
Every day at 11 am (GMT) some the biggest banking institutions are asked what they think they would be charged to borrow money in a ‘reasonable market’ of fellow lenders. The top and bottom quartile of these rates are then removed, with an average taken of the rest.
This is the (now verging on infamous, in some circles) LIBOR, or London Interbank Offered Rate. The risk-free rate of choice for many.
LIBOR-ious? LIBOR-intensive? Not so much!
Relatively easy to understand, right? That same process is repeated for 5 currencies (including USD, GBP and EUR) across 7 durations. These range from Spot Next (or overnight) all the way to a full 12 months, resulting in 35 different rates that are published for every London business day.
This whole process might generally be considered to be fair, transparent and, as previously noted, simple. As such LIBOR has been used internationally as a benchmark against which a multitude of financial products are based.
Corporate debt, derivatives and mortgages may require a floating (or variable) rate against which to set their own charges. As LIBOR has become the rate against which many financial products are pinned to, the costs of diverging from the norm increase, and so LIBOR has become ubiquitous.
The elephant in the room
So far, I’ve skirted round the word most synonymous with LIBOR: Scandal. Many column inches of the financial press have already been dedicated to the LIBOR Scandal.
A detailed post-mortem of events leading up to – and immediately following – the first suggestions of misreporting is not the purpose of this blog. However, some details for the uninitiated are worth covering.
To cut a long story short: in 2008 reports began to surface of submissions for LIBOR being manipulated. It was being artificially held at a lower rate than that which banks were actually lending to one another.
With many LIBOR-securities this would be making banks a lot of money. Due to the nature of LIBOR’s calculation, this may not have been too much of a problem if only one bank had been doing this. Now seems that at least 20 banks, across 10 countries and 3 continents were implicated in this market manipulation.
It’s been predicted these actions have cost institutions tens of billions of dollars for them to extricate themselves from exposed positions and inflated interest payments.
In July 2017 the UK Financial Conduct Authority (FCA) announced that it would no longer be necessary for banks to submit to LIBOR after 2021. Since then, the LIBOR transition has been taking place.
Transition to what?
Given the shortcomings of LIBOR that the scandal exposed, central banks and regulators set-up various commissions and working groups to identify alternatives to LIBOR.
New alternative risk-free rates have been devised for many major currencies including the catchily named SONIA for British Sterling (featured in a blog next month), TONAR for Japanese Yen, and the rolls-off-the-tongue €STR for the Euro.
We’re still in 2021, and these rates have already been devised. And supervisors, like the Financial Conduct Authority, are encouraging early - and widespread - uptake of these new rates.
As you might imagine, this is quite an undertaking. Pages of guidance have been published to help firms transition away from LIBOR. Whatever new rate is transitioned to will (necessarily) not be the same as LIBOR. So, there’ll be a rate of return ‘gap’ between the old and new rates that may need addressing.
Expectations have been laid down that, given the near 4-year warning companies have had, there should be no disruption come 2022. It is particularly important that consumers should not be negatively impacted by the transition.
Administrators of other benchmarks that are currently underpinned by LIBOR should be confident in how their calculation might change given a new risk-free rate. Moreover, this change must be clearly communicated to users of any benchmark.
LIBOR is pervasive
Financial advisers must take note that their advice doesn’t still lean on LIBOR-based metrics. Financial instrument traders need to ensure instruments linked to LIBOR on their balance sheets are dealt with correctly.
Wholesale brokerages may be exposed to similar risks. Custodians of funds held in trust will need to ensure liquidity levels remain consistent between counterparties over the period of the transition. (Although the FCA notes that transition should not trigger the application of margin or clearing requirements.)
LIBOR is pervasive. The rate underpins an estimated $350 trillion in financial contracts. So, there are a lot of banks, brokerages, financial advisers and wider stakeholders that need to ensure they’re adjusting to this drastic change.
Small oversights could result in not just a damaged reputation, but a damaged balance sheet, so there’s a lot of pressure on. If you’re interested in LIBOR, and understanding how the transition might affect you, the FCA’s LIBOR transition page is a good place to start.
The opinions in this blog post are not intended to provide specific advice. For our full disclaimer, please see the About this blog page.