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What Does the Replacement of LIBOR Mean for You?

By April 24, 2019 July 31st, 2019 No Comments
Libor Rate

Plans to phase out LIBOR by 2021 mean regulators are looking to establish a replacement rate sooner rather than later.

LIBOR, the London Interbank Offered Rate, is the benchmark interest rate at which banks lend funds to other banks in the international interbank market for short-term loans. The benchmark boasts more than $350 trillion of securities and is tied to financial offerings such as mortgages, interest rate swaps, business loans, bonds, and other derivatives.

After a series of scandals and concerns of viability contributed to LIBOR’s imminent retirement, many experts are now looking to the Federal Reserve of New York’s Secured Overnight Finance Rate (SOFR) as an alternate option. Others believe a less volatile rate would serve as the best replacement.

Regardless, HousingWire said that the Federal Housing Finance Agency revealed one of the targets for the GSEs in 2019 will be to find a replacement for LIBOR as its end nears.

The replacement of LIBOR brings many questions to mind. How will the change affect the mortgage industry? Will banks feel pressure to cater to borrowers who might not understand converted interest rates? What does this mean for the appraisal industry?

On Tuesday, April 30, we’ll be covering these topics and more during Lunch & LIBOR, a panel discussion on LIBOR replacement hosted by the Atlanta Chapter of RMA from 11:30 AM to 1:15 PM.

In preparation for the event, read up on some interesting facts about LIBOR, including its history, why it’s important, and concerns regarding its replacement.

LIBOR Rate History

During the 1980s, a need for a uniform measure of interest rates emerged, and so in 1984, the British Bankers’ Association (BBA) put interest-settlement rates in place. Two years later, these rates ultimately became LIBOR, the default standard interest rate for dealings at both the local and international level. More recently, in 2014, the Intercontinental Exchange (ICE) took over the administration of the LIBOR, officially changing its name to ICE LIBOR.

LIBOR is based on five currencies and serves seven different maturities. The currencies include the US dollar (USD), euro (EUR), British pound (GBP), Japanese yen (JPY), and Swiss franc (CHF). The maturity dates are overnight, one week, and monthly ranges of one, two, three, six, and 12 months. Combined, the five currencies and seven maturities equate to 35 LIBOR rates that are calculated every business day.

How is LIBOR calculated?

LIBOR is derived from a daily survey of leading London-market banks that estimate how much it would cost to borrow from each other without putting up collateral. They submit interest rates in 10 currencies covering 15 maturities.

According to BBC News, the most important rate is the three-month dollar LIBOR. For example, the rates submitted are what the banks estimate they would pay other banks to borrow dollars for three months if they borrowed money on the day the rate is being set. Then an average is calculated.

In April 2018, a new proposal to strengthen the LIBOR calculation methodology was published by the ICE Benchmark Administration (IBA). The proposal suggests using a standardized, transaction-based, data-driven, layered method called the Waterfall Methodology.

The Replacement of LIBOR

Once dubbed “the world’s most important number,” LIBOR is (or was, depending on how you look at it) used as a measure of trust among banks. After a handful of controversies and concerns of viability, things started to go downhill for the benchmark.

The LIBOR Scandal

In 2012, the LIBOR scandal revealed that collusion emanating from the financial crisis and going as far back as 2003 was taking place within the ranks. The scandal involved a scheme by bankers to manipulate the LIBOR for the purposes of profit. In other words, they were “gaming the rate” by understating or overstating perceived borrowing rates.

Many major financial institutions were caught in the crosshairs, including Deutsche Bank, Barclays, UBS, Rabobank, HSBC, Bank of America, Citigroup, JPMorgan Chase, the Bank of Tokyo Mitsubishi, Credit Suisse, Lloyds, WestLB, and the Royal Bank of Scotland.

In 2015, former City trader Tom Hayes was found guilty at a London court of rigging global LIBOR interest rates. He was sentenced to 14 years in prison for conspiracy to defraud.

Falling Transactions Volumes

Another major issue for LIBOR? Decreasing transaction volumes. According to the Risk Management Association (RMA), the number of actual interbank borrowing deals has fallen off, and the rates have grown more dependent on the estimates of submitting banks. This means that, because of low transaction volumes, an increasing number of submitting banks have to respond to LIBOR surveys by providing an estimated rate based on “expert judgment” as opposed to an actual rate they have paid or are paying.

The Push to Replace LIBOR with SOFR

In light of the scandals and loss of trust in the system, the Alternative Reference Rates Committee (ARRC) is hoping to replace LIBOR with SOFR for U.S. dollar transactions. The ARRC, which is backed by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York, is recommending a new rate, along with a transition plan, that is set to include “triparty repo data from Bank of New York Mellon, cleared bilateral repo transactions, and general collateral finance repo data from the Depository Trust & Clearing Corporation.”

Challenges During the Transition

Undoubtedly, there will be many challenges that follow LIBOR’s transition period. One major issue is the divide between interbank offered rates (IBORs) and risk-free reference rates (RFRs). RMA gives this example:

“Because LIBOR is an unsecured rate based on interbank borrowing, it includes an element of credit risk tied to the strength of banks and the banking industry. Transitioning to SOFR will necessitate adjustments. Whatever those may be, industry groups are stressing that they should be simple, transparent, fair, and minimize ‘winners and losers.’”

Other concerns involve whether or not customers can be convinced that the new converted rates are fair. Others fear that banks will favor borrowers, resulting in further losses. Some concerns stem from the implementation of SOFR itself due to its status as a volatile overnight rate.

Looking Forward

There’s no denying that the replacement of LIBOR will require considerable effort and substantial cost. But what does the replacement of LIBOR mean for the financial industry? The experts weigh in:

“LIBOR continues to represent an important basis for pricing and risk management, even after the [most recent] financial crisis, when certain derivatives dealers began discounting collateralised swaps at an overnight rate,” said James Schwartz, Of Counsel at Morrison & Foerster. “The move away from LIBOR, from the standpoint of pricing and risk management, will require significant resources and coordinated efforts across risk, pricing, and operations.”

“Effecting change in financial markets invariably involves cost and considerable effort, and this is certainly the case with the shift from LIBOR to an alternative RFR,” said Andy Ross, the Chief Executive at CurveGlobal. “But it’s worth remembering that the new benchmarks are robust, backed by central banks globally and based on actual transactions.”

“There will potentially be a cascade of reactions to removing LIBOR and LIBOR-linked trades as modelling inputs,” said Jonathan Rosen, Ph.D. and product manager quantitative analytics at Fincad. “Interest rate curves at the various LIBOR tenors will disappear, leaving far fewer curves available to a market that has been multi-curve for a decade.” Rosen continued. “However, investors cannot forget the embedded credit risk in term lending. This means it could be necessary to include more complex credit models — such as credit valuation adjustment exposure modelling on a sector basis — to recover the full multi-curve modelling that is currently standard.”

“The real test of the timetable [by 2021] is not the U.S. and E.U. migration to a new RFR, but the creation of RFR term rates to mimic the LIBOR fix-in-advance pay-in-arrears procedure,” said Christian Behm, partner at LPA. “The simplest method to derive term rates would be to use short OISs with a maturity of up to one year, which would be a challenge.”

Considering what the experts had to say, it’s clear that the LIBOR replacement will have an unavoidable effect on the financial industry — how big that effect will be is still yet to be determined. As regulators prepare for the transition in 2021, we can only look back on what we know about LIBOR’s history to prepare for any challenges that may come in the future.

In summary, here’s what we’ve learned:

  • LIBOR, the benchmark interest rate, was born out of a need for a uniform measure of interest rates.
  • LIBOR is calculated based on a daily survey of leading banks that estimate how much it would cost to borrow from each other without putting up collateral.
  • For almost 30 years, LIBOR was considered “the world’s most important number.”
  • Scandals and viability concerns lead to replacement talks with talks of phasing it out entirely by 2021.
  • The ARRC is hoping to replace LIBOR with a new benchmark called SOFR for U.S. dollar transactions.
  • The transition will not be easy, but having a set plan in place will ease tensions and concerns.

Now that you’re caught up on the history and happenings of LIBOR, you’re ready to join us for the Lunch & LIBOR event on April 30.

Event Details

  • What: Lunch & LIBOR Panel Discussion
  • Who: The Atlanta Chapter of RMA
  • When: Tuesday, April 30 from 11:30 AM to 1:15 PM
  • Where: The Georgian Club, 100 Galleria Pkwy SE, Suite 1700, Atlanta, GA
  • Tickets: $40 for members, $50 for non-members, $55 at the door