Life after Libor

Libor, the long-standing but much maligned mechanism used to set lending rates, is being ushered out in favour of ‘risk-free rates’. So could the removal of a global rate-setting standard and a potential change of rates for existing loans prove a headache for borrowers and banks alike?

As crimes go, the Libor rigging scandal may not have captured the public imagination in the same way as the Brink’s-Mat robbery or even trader Nick Leeson’s near devastation of Barings Bank, but it was to have major ramifications for the financial system.

Tom Hayes, the first person to be found guilty of fixing the Libor rates – used to underpin the amount of interest lenders can charge – was released from prison at the end of January this year. He had served half of an 11-year sentence, a prison term that perhaps indicates the severity with which the judicial system viewed the offence.

While not a household name, Libor – the London Interbank Offered Rate – is of fundamental importance to all of us. The rate is used to decide how much interest borrowers will pay on trillions of assets covering everything from corporate bonds to mortgages and individual loans. 

However, despite its prominence, Libor is fatally flawed – and the Financial Conduct Authority (FCA) said in 2019 the rate will cease to exist from the end of 2021.

Libor’s problems are two-fold. First, it is set by a panel of banks that decide the rate at which they think they can charge each other, based on the current market conditions. 

Leaving aside that, at best, Libor is somewhat subjective, the rate-rigging scandal rather conclusively demonstrated that it was vulnerable to fraud.

Lee Morris, Investment Director at Rathbone Investment Management International, says: “The widespread manipulation of Libor after the global financial crisis, together with the dwindling number of interbank borrowing transactions, caused regulators to question Libor’s future. 

“There were only 15 interbank lending transactions of an appropriate tenor and size in 2019 for Libor-setting purposes – hardly enough to produce a reliable industry benchmark.”

The rate’s second weakness lies in its volatility. Since Libor-setters consider credit risk, when markets and economies are in a state of stress – such as we have seen repeatedly during the past 12 months of the Covid-19 pandemic – rates get choppy.

Untangling from Libor

Yet while Libor’s demise seems eminently sensible, replacing it is no small undertaking. According to Stephen Farrell, Audit and Assurance Partner at Deloitte, ditching Libor represents one of the biggest changes to the global financial system since the upheavals that followed the 2008 credit crunch.

“[Moving from Libor] is the financial equivalent of trying to get rid of Japanese knotweed. Once it is enrooted and under your pavement, you have to do a significant amount of work to remove it,” he says.

Farrell explains that banks and lenders are still trying to work out how many contracts reference Libor before they can even begin to start switching loans to an alternative rate. 

Getting ready for the change, then, even with three years’ warning, is a notable undertaking – even without the recent impact of the coronavirus pandemic of the past 12 months. 

Regardless, any hopes for a Covid-19-related reprieve were dashed by former FCA chief – now Governor of the Bank of England – Andrew Bailey in July 2020.

Speaking at a webinar hosted by the Bank of England and the Federal Reserve, Bailey said: “With the authorities, businesses and households all having to adapt to the challenges of lockdown and new ways of working, there have been calls to step back from the Libor transition as a priority.

“We understand the level of disruption there has been, and central banks have worked to ensure financial institutions have had the support and capacity to be able to ensure a continued flow of financing to support the economy. 

“But what we saw in financial markets in March in response to the shock of Covid-19 only reinforces the importance of removing the financial system’s dependence on Libor in a timely way.”

Businesses and financial institutions in the US have slightly longer to switch away from Libor, but for the UK and its related jurisdictions, it is full steam ahead.

Thomas Wakefield, Senior Product Manager, Lending and Portfolio Management, Europe, at HSBC, says: “The deadline of the end of this year is fast approaching, so the time for businesses to act is now.”

Proactive response

The amount of work involved in switching from Libor to an alternative rate will vary across businesses and will depend on the level of borrowing or lending.

For some businesses, it will be necessary to set up a dedicated project team with the appropriate funding, while for other organisations, leaving Libor’s administrative demands to their bank may be all that will be required.

However, should the latter prove sufficient, Jerry O’Keeffe, CEO of JCAP Treasury Services and President of the Channel Islands Treasurers Association, advises corporates against a passive approach.

“Businesses can take [the Libor transition] as a project, put in some resources and ask, ‘What is our exposure?’. Or they can do the opposite and think that the banks will do it for them,” he says. “The danger is that this may just be taking what the banks offer rather than being proactive and choosing the best rates.”

Wakefield agrees and suggests that businesses communicate with their advisers and banks and understand not only their exposure but the products and solutions that are now available.

Most importantly, businesses need to understand which rate they want to use as an alternative.

One of the advantages of Libor was its consistency; pretty much all borrowers and lenders used it. Under the new system, there will be a range of risk-free rates from which to choose.

One Chartered Project Manager based in the Channel Islands – who asked not to be named – says: “There are a lot more potential rates that are going to be floating about. Every country is basically having to develop its overnight rate, while some existing rates are not disappearing overnight. All this complicates the move from Libor a bit more.”

The favoured alternative, at least for sterling investors, is the Sterling Overnight Index Average (SONIA) rate, which is administered by the Bank of England and based on overnight interest rates in active and liquid wholesale cash and derivative markets. 
  
Rathbone’s Morris explains: “This makes SONIA more robust and less volatile than Libor. It is also virtually risk-free as it does not incorporate any credit risk/liquidity premium – which is inherent in the calculation of Libor because Libor is predicated on banks lending to each other over longer time periods.”

Irrespective of the rate preferred, businesses need to start making changes to their existing loans.

Morris says: “Lenders and borrowers should review their facility agreements. Changes to existing loans are likely to be required to transition to SONIA, even where those facility agreements incorporate interest rate benchmark fallback.”

For new loans, he says, it makes sense to use an alternative rate, but if Libor is referenced in loans issued in the first half of this year, they should contain provisions to switch.

Businesses also need to ensure that their systems and processes can cope with the demands of a new rate.

Wakefield says: “At the moment, businesses typically have 30 days to confirm the amount of interest that they will have to pay under Libor. Under SONIA, that will be reduced to just five days, which is a significant reduction in that notice period. 

“Businesses will need to assess if this is acceptable and whether their internal accounting and operating systems will cope.”

For regulated financial institutions, the Libor switch should have been afforded primacy from at least 2020, and it is likely that most of these organisations have prepared for the switch. 

For other corporates, particularly given the recent distractions of Covid-19, it is possible the move to a new risk-free rate has dropped down the priority list. 

And while Libor may not seem to be such a pressing issue at the moment, failure to manage the transition presents a significant business risk.

But, as Morris points out, even for those late starters, the Channel Islands are well equipped to make the change a relatively pain-free operation.

“Jersey is an island of international financial experts and we’ve got the resources and capabilities to do deal with [the end of] Libor fairly easily,” he says. 

“The central authorities have been very clear that this is an important issue, but so far the switch has proved a great example of where industries, practitioners and regulators are working together. 

“Although it needs to be done over a short, tight time frame, the transition out of Libor could be relatively smooth sailing.”