Most lenders and borrowers will undoubtedly have read about the $453 million of fines levied against Barclays Bank PLC for manipulating its London Interbank Offered Rate (LIBOR) submissions between 2005 and 2009, as well as the ongoing investigations of other major banks that participate in setting LIBOR (including Citigroup, HSBC, Royal Bank of Scotland and UBS). While the fines and allegations have made headlines, many market participants seem to be relatively unaware of the initiatives currently underway to modify, or even eliminate, LIBOR as the primary benchmark for short-term interest rates globally.1
The UK government recently commissioned Martin Wheatley, the prospective chief of the new Financial Conduct Authority in the UK, to prepare a discussion paper on LIBOR to address the concerns arising from the existing system and propose possible solutions. Wheatley released his draft for public review and comment in August (the Wheatley Review), with a deadline for comments set for today. The UK Parliament is expected to use the Wheatley Review, as it may be modified to reflect third-party submissions, as the basis for reforms to the Financial Services Bill. Such reforms are anticipated to be approved as early as this fall.
By way of background, LIBOR is currently published in ten currencies and 15 maturities by the British Bankers’ Association (BBA) and is not regulated by the UK’s Financial Services Authority or any other governmental authority. The various LIBOR rates are calculated using daily submissions from reference panels of between six and 18 international contributor banks; rate submissions are voluntary and are not necessarily based on actual transactions on any given day. Every contributor bank is asked to provide its LIBOR submissions based on the following question:
At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 a.m.?
Each contributor bank therefore submits the lowest rate (either actual or perceived) at which it could go into the London interbank money market and obtain funding in reasonable market size for a given maturity and currency. The BBA drops the highest and lowest quartiles of the rates provided by the contributor banks and calculates LIBOR as the mean of the remaining 50 percent of submitted responses. In theory, LIBOR should provide an accurate, frequently updated indicator of banks’ real costs of unsecured funding in the London interbank market.
Until the recent rates rigging scandal, it was presumed that even though the LIBOR submission system was voluntary and based on unsubstantiated market data, there would be little incentive for a contributor bank to underreport its cost of borrowing, as such underreporting would eventually reduce the bank’s earnings on its own loans based on LIBOR. During the credit crunch, however, banks increasingly began to worry about the credit risks posed by their counterparts. Any bank perceived to pose such a risk would, naturally, be charged a higher rate for any credit extended to them, a signal that could precipitate a run on the bank. Institutions that wanted to allay any concern about their own credit risk were therefore incentivized to lower their LIBOR submissions below the rates that they might actually be able to obtain in the market.
Given the inherent flaws in the system, the UK authorities have been strongly motivated to revise and perhaps even regulate LIBOR, prompting the commission of the Wheatley Review. The Wheatley Review goes into some detail on the background and use of LIBOR and proposes several possible changes, including:
- calculating LIBOR using the median of submissions rather than the mean
- increasing institutional accountability and governmental regulation of LIBOR submissions and criminal penalties in relation to misconduct
- basing submissions on a larger panel of banks, a larger number of products and/or verifiable trades in the market
- reducing the number of currencies and maturities for which LIBOR rates are submitted, and
- at the extreme end, constructing a new alternative interest rate instrument other than LIBOR, which would be regulated by an international body rather than the BBA.
Although it is not yet clear which, if any, of the above changes will be made to LIBOR, it is fairly evident that change will be forthcoming. Any modifications to the calculation, use or regulation of LIBOR could have a significant impact on the entire financial system, as the Wheatley Review estimates that LIBOR is used in transactions involving anywhere from $300 trillion to $800 trillion. Such transactions range from complex interest rate hedges between sophisticated financial institutions to adjustable rate home mortgages offered by local banks in small-town America. Fortunately, regulators have made clear that any transition would need to be carefully planned and implemented over the course of multiple years, but in the meantime it is important to watch this space for ongoing developments.
- Borrowers and lenders of LIBOR-based loans should consider reviewing the market disruption provisions in their loan documents to determine what rates would apply in the event that LIBOR is no longer available or the lenders determine that it no longer reflects their cost of funding. Such provisions often allow lenders to use a base rate or a rate mutually agreed upon, but some may allow lenders to select an alternative rate on a unilateral basis.
- Lenders may wish to consider revising the market disruption provisions of their form loan documents to ensure clarity in the event that LIBOR is no longer available.
- Given the ongoing uncertainty regarding LIBOR, lenders may wish to determine whether LIBOR truly reflects their own cost of funds and consider offering alternative rates to their borrowers.