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The risks of the phasing out of LIBOR

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The risks of the phasing out of LIBOR

It
has been called the world’s most important number. LIBOR, which stands for the
London Interbank Offered Rate, is a benchmark interest rate, representing the
amount that banks pay to borrow unsecured from each other. Globally, it
underpins $260trn of loans and derivatives, from variable-rate mortgages to
interest-rate swaps. But LIBOR’s days are numbered. It is due to be phased out
in three years. Broadly speaking, LIBOR’s planned demise is a good thing. But
that does not mean it will go smoothly.

The case for moving away from
LIBOR as a reference rate is powerful. The rate is based on a panel of banks
submitting estimates of their own borrowing costs. The rigging scandals that
made LIBOR notorious in 2012 showed how this process could be manipulated. They
have also made many banks nervous of being involved. The interbank market has
become less important since the financial crisis, because new rules encourage
banks to use other forms of borrowing. That means there are fewer transactions
to base the rate on. Anyway, it is unclear why a measure depending in part on
banks’ credit risk should be part of an interest-rate swap, say, between two
companies.

Hence
the decision by British financial regulators to cease requiring banks to submit
rates after 2021. Hence, too, the race by central banks, regulators and the
industry to cook up replacements. An alphabet soup of new reference rates, from
SOFR and SARON to SONIA and TONAR, is already simmering away.

Two risks

Welcome
though it is, the end of LIBOR poses two risks. One is of market instability,
as trillions of dollars-worth of financial contracts that are based on LIBOR
are forced, after its discontinuation, to anchor themselves to a new benchmark
rate. That shift could have big effects, such as a sudden jump to higher
interest rates for borrowers. This is not just a theoretical concern. The Bank
of England pointed out in June that in the previous 12 months the stock of
LIBOR-linked sterling derivatives stretching beyond 2021 had grown. The answer
to this is for contracts to have proper “fallback” clauses which specify what
happens when LIBOR disappears. Regulators are applying pressure to get these
included, but efforts to amend existing contracts before 2021 could easily end
up in the courts. 

The
other risk concerns the post-LIBOR world, where the new reference rates may
cause banks’ assets and liabilities to become disconnected. Flawed though it
is, the use of LIBOR offers banks a hedge against sudden moves in their own
borrowing costs. The interest rates they charge and the interest rates they
pay, whether for one day or one year, are linked by LIBOR.

The
alternatives may not move in sync. They refer to the cost of borrowing
overnight, not for a range of maturities. The rate being promoted by the
Federal Reserve is for borrowing secured against American government
securities. In a crisis, it is easy to imagine that demand for such
high-quality collateral would go up even as willingness to lend to banks goes
down. That would mean banks’ income from loans would fall just as their own
borrowing costs rose. 

Neither of these dangers can be
wished away. Finding a rate that is both immune to manipulation and an accurate
reflection of banks’ borrowing costs is hard. And replacing a number that has
become embedded in the financial system risks instability.

Source : The Economist

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