Why Ditching Libor Is Vexing the Financial World

(Bloomberg) -- For half a century the series of interest rates known collectively as the London interbank offered rate, or Libor, has helped determine the cost of all sorts of borrowing around the world. Now seen as outdated and discredited, the benchmark is being killed off from the end of this year. That’s sent the financial world scrambling to adjust the terms in contracts on hundreds of trillions of dollars’ worth of products — from mortgages and credit cards to interest-rate swaps. Life after Libor could be messy, and major global banks will spend more than $100 million each in 2021 in preparation for its demise.

1. What is Libor?

Libor is a daily average of what banks say they would charge to lend to one another. It’s offered in five currencies and over various time periods, up to one year. Formalized by the British Bankers’ Association in 1986 to help set prices for derivatives and syndicated loans, Libor is used by pension and fund managers, insurance providers, big and small lenders and Wall Street banks that package loans into securities. Some $370 trillion worth of financial products are tied to the benchmark, including equipment leases, student and auto loans and bank deposits. The biggest component is derivatives such as interest-rate swaps — trades of a fixed interest rate for a floating one or vice versa — which are used by companies, banks and investors to hedge risk or speculate. Of the five Libor currency rates, the one tied to the U.S. dollar (“dollar Libor”) is most widespread, accounting for more $200 trillion worth of products.

2. Why is it disappearing?

As markets evolved, the trading that helped inform banks’ estimates dried up. Evidence emerged in 2008 that European and U.S. lenders had manipulated rates to benefit their own portfolios, tainting the benchmark and resulting in a dozen banks paying billions of dollars in fines. In 2017, the Bank of England decided that Libor would be phased out by the end of 2021.

3. Why is killing Libor such a challenge?

The finance industry needs to find suitable replacements. Beyond that, there’s the fate of millions of Libor-priced contracts that run past 2021, known as legacy contracts. Updating legacy contracts can prove a complicated process, raising the risk of a chaotic transition that has been likened by some to Y2K and the fear of computer systems misfiring at the end of the last millennium. Rather than planes potentially falling from the sky, the worry is that a mass of litigation will ensue as lenders and borrowers fail to agree on what rate to pay following Libor’s exit.

4. Does that mean trouble is coming?

Several developments have eased the concern. Regulators in the derivatives market established a protocol to include so-called fallback language in contracts that will automatically transition them from Libor. In the U.S., New York state approved a law that provides a further backstop for contracts hatched on Wall Street. President Joe Biden’s administration and the U.S. Federal Reserve are pushing for legislation to mop up anything else. Vitally, regulators extended the deadline until the end of June 2023 for dealing with legacy contracts priced in most dollar Libor rates. Most of those contracts will have expired by then. Regulators reiterated that no new dollar Libor contracts can be issued after 2021.

5. How are Libor’s replacements shaping up?

Central banks have been working to develop benchmarks that are a truer reflection of the cost of capital and based on actual transactions. One common problem has long been that some new benchmarks, such as the Secured Overnight Financing Rate in the U.S., mostly reflected overnight borrowing rates. Borrowers disliked that because they were less able to predict payments, and loans wouldn’t reflect expectations of rate changes — key attractions of Libor. Also unlike Libor, the new rates fail to capture the credit risk that banks assume when they lend to each other. During the 2008 financial crisis, Libor jumped even as central banks cut interest rates because of the heightened risk that lenders would go bust.

6. What do these shortcomings mean?

In the U.S., alternative benchmarks that offer longer-term rates and incorporate credit risk are gaining popularity with borrowers and banks. The likes of Ameribor, published by the American Financial Exchange, have the potential to disrupt the transition to SOFR by splintering the trading that’s needed to establish the official replacement for Libor. That pushed officials overseeing the transition to spring into action to address some of the concerns about the rate’s main replacement, and in July they formally endorsed a series of forward-looking term benchmarks tied to SOFR based on futures trading. Many anticipate this will propel its wider adoption across markets including syndicated corporate loans and collateralized loan obligations, which have been hesitant to embrace the benchmark.

7. Will regular consumers be affected?

There’ll be scrutiny over whether regular borrowers will be forced to pay higher interest rates after the switch from Libor. Analysts say banks and asset managers face a greatly increased risk of fines, litigation and reputational damage if they poorly manage the transition, with regulators likely to be watching closely whether they are treating customers fairly.

Reference Shelf

• Bloomberg Opinion’s Brian Chappatta says SOFR has weaknesses that others are trying to exploit.
• Keep updated by subscribing to Bloomberg’s Libor Countdown newsletter.
• The Bank of England provides resources about the transition.
• QuickTakes on why Libor’s end is a headache for loan bankers -- and for Switzerland. And another on what China is doing.
• Bloomberg details the new benchmarks emerging to replace Libor.

©2021 Bloomberg L.P.