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.
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