The End of LIBOR- A Formidable Necessity?

LIBOR or London Interbank Offered Rate is the inter-bank lending rate of several big banks situated in London. It is the rate at which these big banks lend to each other on a short-term basis without any security. This rate serves as the basis for determining the borrowing costs for various other banks and businesses. The rate expresses the borrowing costs in five currencies, namely, Dollar(USA), Yen(Japan), Franc(Switzerland), Pound(Britain), and the Euro. Moreover, these rates are expressed for periods varying from overnight to a year.

When these rates are used as reference rates by other lenders or financial institutions, it is typically in the form of LIBOR+”x”%, where x is the premium added as per the borrower’s creditworthiness. The reason for this is, the LIBOR represents the rate at which the most financially sound banks with very high creditworthiness in London can borrow. It serves as the lowest rate at which other financial institutions may choose to lend even to a person of the highest creditworthiness. Accordingly, these banks add the premium rate or “x” on the credibility of their borrowers.

REASONS FOR REMOVAL

In 2012, allegations arose that these large banks of London involved in determining LIBOR have deliberately shown lower borrowing costs during the financial crisis of 2007 to create a false perception of their financial stability and soundness. It was also alleged that, rather than one bank resorting to underreporting its borrowing costs, it involved a concerted effort on the part of several banks to reduce the LIBOR rate and make profits on it.

 There were also times when the LIBOR rates were much above the prevailing market rates. It was alleged that these banks were wrongfully making profits from the market by investing in various securities or shares and then fraudulently increasing the interest rates to incentivize more people to turn towards the stakes or share market.

 As a result of these allegations, there were several regulatory and structural changes imposed on the LIBOR. One of the most significant changes was the introduction of the International Exchange Benchmark Administration. As per the new procedure, these banks of London, every morning, report data about various transactions that they entered into with other big banks to the International Exchange Benchmark Administration(IBA). The IBA, in turn, determines the LIBOR rates.

 Ever since the 2008 financial crisis, the number of panel banks( the big banks in London reporting rates for LIBOR calculation) has plummeted. Even the banks that continued saying started writing a fewer number of transactions.

Consequently, LIBOR began to significantly based on the judgment of experts who determine the rates using the transaction data reported. It led to a further decline in the efficiency of LIBOR rates as borrowers often look for rates that are more based on accurate data than estimation to determine their funding costs. Also, the methodology of calculating LIBOR hasn’t changed much during the last few decades as the markets have grown in size and become more complex. It has consequently reduced the credibility of LIBOR. Therefore, it was decided by the Alternative Reference Rate Committee(ARRC) that the use of LIBOR shall be discontinued globally at least partially, if not wholly, after December 2021.

IMPACT AND ALTERNATIVES TO LIBOR

As the date draws closer, several competitors or alternative reference rates are vying to replace the LIBOR. While the ARCC has recommended the SOFR ( Secured Overnight Financing Rate), various countries are trying to promote their rates to be used simultaneously with the SOFR.

Country LIBOR RateNew RiskFree Rate
USAUSD LIBORSOFR
U. K.  GBP LIBORSONIA
Japan TIBOR, JYP LIBOR and Euroyen TIBORTONA
EuropeEURIBOR and EURLIBORESTER
Source: Morgan Stanley Research(Transitioning Libor: What it means for Investors, Oct 29,2019)

The USA’s SOFR is most likely to replace the LIBOR rate. However, it wouldn’t be possible for institutions to replace LIBOR with SOFR without any further adjustments completely. It is because of four primary differences between SOFR and LIBOR. The first being, while LIBOR releases rates for a period varying from an overnight basis to a year, SOFR releases rates for just an overnight basis. Secondly, while LIBOR is based on unsecured borrowing, SOFR uses the data from transactions secured using US Treasurys( securities issued by the Federal Reserve) as collateral. Thirdly, while LIBOR eventually became entirely based on expert judgement, SOFR is solely based on the data available of transactions. Lastly, while the LIBOR rate involved borrowing by several large banks in London that were financially stable, it still included some risk premium ( adjustment of the interest rates, which is done based on the borrower’s creditworthiness), as these banks weren’t entirely sound. However, in the case of SOFR, the involvement of the US Treasurys, which are arguably the safest securities in the world because the Federal Reserve can always print more dollars as the USD is an international currency, makes these transactions more risk-free than LIBOR was.

CONCLUSION

Most borrowers( such as credit card owners) have a vague sense of what LIBOR is. However, the impact of LIBOR’s discontinuation will be widespread as the LIBOR rate is used as a reference rate for calculating various rates on interests and costs of funding. The rates determined with the help of LIBOR, are in turn, often used as reference rates for different local lenders. Choosing funding or borrowing costs and the interest rates to be charged for multiple types of credit provided by them is a complicated task. Several factors such as the risk premium – increase in the interest rate as per the estimated risk of the borrower defaulting on repayment, liquidity premium, which is an adjustment to the rates on a reasonable estimation of the possibility that the economy may face a liquidity crunch, thereby increasing the cost of borrowing for banks which have locked their funds in long-term credits and now need money to meet their obligations as their customers are suddenly withdrawing their deposits due to uncertain economic conditions, taxes payable on availing various types of credit, general economic conditions, collateral, etc have to be taken into consideration while determining these rates. Thus, a transition from LIBOR to any other indicator will pose formidable challenges before the banks. Several clauses would have to be added by the banks in their contracts specifying the changes that have taken place and the new methodology used for the determination of interest to be charged. It may be high time for banks worldwide and Indian banks, particularly, to become digitized and leverage artificial intelligence to carry out this complex task.

REFERENCES

Hou, David. LIBOR: Origins, Economics, Crisis, Scandal and Reform and The End of the Road for LIBOR:Handling the Impact on the Financial World. Tata Consulting Services.

Morgan Stanley

https://www.morganstanley.com/ideas/libor-its-end-transition-to-sofr

Skeiee, David. published in Staff Report No. 667, Federal Reserve Bank of New York,March 2014.

Sidharth Badlani is a B.Com(Honours) student at the Ramjas College.

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