European Borrowers Find Breaking Up With Libor Is Hard to Do

(Bloomberg) -- Borrowers are yet to take the plunge and switch away from the familiar world of the London interbank offered rate and its euro equivalent as they wait for reliable new reference rates that offer a range of maturities.

So far this year, 10 issuers have raised bonds based on the Sterling Overnight Index Average but none have done so in the European loan market. Using Sonia will remain problematic until risk-free term rates emerge that mimic the three- or six-month tenors typically used by borrowers and lenders.

Switching to Sonia now would see borrowers having to work off overnight rates that don’t set the interest payment until the end of the time period. This route is unappealing for debtors since they are used to knowing how much interest they owe ahead of time, and is also difficult for bank back offices to handle.

“Compounded overnight rates require significant systems changes, which will take time to test and adopt. That’s inhibiting their use in the loan market,” Clare Dawson, chief executive of the Loan Market Association, said in an interview. “Many borrowers want to use something more familiar and forward-looking, to give them certainty of cashflow.”

The question for banks is how long they they will wait for suitable term rates to emerge. By continuing to raise new loans based on Libor or Euribor, they are adding to the volume of outstanding debt that will need to transition to new reference rates. The U.K.’s Financial Conduct Authority plans to scrap the benchmark by 2021, following a series of manipulation scandals amid the global financial crisis.

Term Rates

The development of a rate curve with a range of maturities relies on increased liquidity in Sonia-linked derivatives, which will take time, according to the LMA’s Dawson. The Bank of England held a consultation last year on term rates and published results in November, noting that a “step change” would be needed before Sonia derivatives markets are robust enough for this purpose.

LMA Looks Beyond Overnight Libor Heirs for Something Longer Term

“Whether banks will wait for term rates, or make the more complex systems changes necessary to handle compounded overnight rates, depends on how confident they are that those term rates will be developed,” Dawson said.

The immense task of shifting all loans across to Libor and Euribor’s successors is made more complicated by the differing rates of progress for different currencies. "It’s unlikely that they’ll all arrive at the same time -- and many loans are multi-currency of course," Dawson said.

To allow loans to transition, the market also needs to agree on an adjustment spread for legacy deals, among other issues. In the interim, the LMA is working on loan documentation to ease the changeover once term rates are up and running.

“It’s a big issue for the market, but the good thing is that everyone is engaged, either through working groups or trade associations, trying to come up with a solution. It’s a huge task but everyone is pitching in," Dawson said.

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