BOE to Cut Lending to Banks Using Libor-Linked Collateral

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(Bloomberg) --

The Bank of England is heaping pressure on banks to abandon the scandal-tainted Libor benchmark.

Firms will be able to borrow less money from the central bank starting in October if they use securities linked to Libor -- which underpins $30 trillion of financial contracts in sterling markets -- as collateral. The measure, announced Wednesday, will effectively penalize firms still clinging to the benchmark before it expires at the end of 2021.

“Everything to date has been a push from behind but this becomes a very heavy commercial stick,” James Lewis, a director and co-lead on Libor at KPMG U.K., said by phone. “This is really starting to go to the heart of the commercial business.”

The BOE in 2017 started the countdown on retiring Libor, used for $300 trillion of contracts globally including bonds and loans. For decades the rate served as a benchmark set daily by banks to determine interest rates on everything from student loans and mortgages to derivatives and credit cards. But ever since European and U.S. banks were found to have manipulated it to benefit their own portfolios, the benchmark has been tainted.

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The BOE also announced Wednesday that, starting July, it would publish a compounded index for the Sterling Overnight Index Average, its preferred replacement for British pound Libor. Determining coupons using the Sonia benchmark has previously involved a complicated back-and-forth process referring to individual bond prospectuses, helping create confusion.

“If you don’t have consistency in the market about how you calculate Sonia for bonds and derivatives and loans then you haven’t got the certainty to deliver products,” said Tim Rennie, a partner at law firm Ashurst LLP. “Having a BOE published rate is a great development. The question I have is -- will the market adopt it as the only option.”

At present the central bank makes an average reduction of 25% on the value of Libor-linked collateral when deciding how much to lend, in a process known as haircutting. The BOE will increase this by 10 percentage points in October, and by a further 30 percentage points in mid-2021. It will cease to lend against Libor-linked securities at the end of next year.

The BOE’s Executive Director for Markets Andrew Hauser said the measures would give firms the time to replace the collateral and maintain their borrowing capacity while protecting public funds. The arrangement will apply to banks and other financial intermediaries.

Hauser said Libor is too fragile to support a sustainable business model, adding that it posed risks to national and global financial stability. About a 10th of banks’ drawing capacity is collateralized with assets that reference sterling Libor.

“The first step is a bit more muted but then it really ramps up,” said Shankar Mukherjee, a partner at Ernst & Young LLP, referring to the BOE’s planned measures. “The treatment is like you would treat a junk bond.”

©2020 Bloomberg L.P.

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