On September 28, 2012, a review team headed by Martin Wheatley, managing director of the British Financial Services Authority and CEO-designate of the new Financial Conduct Authority, published its conclusions and recommendations regarding the system used to determine the London Inter-Bank Offered Rate (LIBOR). The Wheatley Review of LIBOR (Review) may have significant ramifications for financial institutions and their customers who use LIBOR in loan, derivative and other financial product transactions.
LIBOR is the most widely used global interest rate benchmark. Currently, LIBOR is determined by the British Bankers’ Association (BBA) and is published daily by Thomson Reuters, Bloomberg and other financial information service providers. LIBOR is currently comprised of 150 different benchmarks in 10 currencies for 15 different maturities. Together, these rates affect loans, derivatives and other financial products with an estimated global notional value of at least US$300‑trillion. Currently, the BBA surveys a panel of banks – for US Dollar LIBOR, the panel has 18 banks – as to the rate at which they could borrow unsecured funds in the London inter-bank market immediately prior to 11 a.m. on that day. The four highest and four lowest submissions are excluded, and the remaining 10 submissions are then averaged to arrive at that day’s rate.
In June 2012, in response to recent investigations and announced settlements regarding the alleged manipulation of LIBOR, the British Chancellor of the Exchequer appointed Mr. Wheatley to conduct an independent review into LIBOR. The Review looked only at reforming the current framework of LIBOR, and not at any specific allegations against particular financial institutions or individuals.
The Review published a discussion paper in August 2012, and allowed for a brief comment period that expired in early September 2012. The discussion paper noted two inherent conflicts in the process of setting LIBOR. First, contributing banks are users of LIBOR and therefore have assets and liabilities that are sensitive to changes in LIBOR. This can result in an incentive to seek to affect the overall LIBOR rate for the benefit of a particular exposure. Second (and conversely), a bank’s daily LIBOR submission may be interpreted by observers as an indication of the creditworthiness of that bank. During periods of market stress, this may create an incentive to lower submissions to avoid a negative perception of relative creditworthiness. The discussion paper sought ways to manage this inherent conflict. The final report was issued at the end of September.
WHEATLEY REVIEW RECOMMENDATIONS
The final Review dismissed calls by some commentators to eliminate LIBOR altogether, concluding that LIBOR is too deeply entrenched in the market to do so. Accordingly, assuming that the recommendations are adopted, LIBOR will continue to be a rate determined from a compilation of submissions by private banks, administered by a private central authority. Nevertheless, there will be a number of significant changes to the system by which LIBOR is determined.
The Review recommends that the BBA convene a committee to tender out to an independent organization the process of setting LIBOR, with increased transparency controls and accountability, and a new specific oversight process. The tender committee will have government and regulator representation, and an external oversight committee will be established in the future with similarly independent representation.
Banks that make submissions to LIBOR will be required to base their submissions on actual transaction data from the unsecured inter-bank deposit market and other related markets. Currently, it is possible – and, the Review suggests, common – to have a LIBOR rate that does not reflect actual inter-bank lending rates. Submitting banks will be required to keep records of their submissions and supporting transactions, and to comply with a regular external audit requirement.
The Review rejected the suggestion that individual LIBOR submissions continue to be made public immediately to enhance transparency, but recommended that individual LIBOR submissions be published only after three months, to reduce the risk that published submissions will be used as a measure of a bank’s creditworthiness. More banks will be encouraged to participate in the LIBOR compilation process, and the Review left open the possibility that regulators will compel banks to participate if necessary.
The Review recommended ceasing publication of LIBOR for a number of currencies and maturities that are underused. This would include Canadian Dollar, Australian Dollar, New Zealand Dollar and the Swedish Kronor LIBOR rates; the 4-month, 5-month, 7-month, 8-month, 10-month and 11-month maturity LIBOR rates; and possibly even the overnight, 1-week, 2-week, 2-month and 9-month LIBOR rates. If fully implemented, the result would be to reduce the number of LIBOR rates from 150 benchmarks to 20, each of which would be expected to be more fully supported by actual market data.
The Review also called for a specific criminal sanction for the manipulation of LIBOR, concluding that current sanctions for market abuse are insufficient, in that they were designed to capture market abuse in relation to financial instruments, but not benchmark interest rates.
The Review suggests that, in some cases, financial institutions and their customers should consider whether LIBOR is the most appropriate benchmark to use for a given transaction. The Review also suggests that market participants should review standard contracts to ensure that they contain adequate protections to deal with a scenario where LIBOR is not produced.
While LIBOR is used infrequently in current transactions to determine interest rates on Canadian Dollar loans, there are “legacy” deals in the marketplace which use LIBOR for Canadian Dollar-denominated deals. Changes will be required for those deals. For financial institutions and their customers using US Dollar LIBOR, careful attention will need to be paid to ensure that credit, derivative and other financial product documentation refers properly to LIBOR. Some credit documents refer to the rate set by the BBA, and these documents may need to be updated once a new administrator is put in place. Where credit, derivative or other financial product documentation looks to a LIBOR benchmark which is to be eliminated (i.e., to LIBOR for one of the currencies or maturities for which the rate is to be discontinued), parties will need to ensure that documentation provides for adequate determination of an alternate rate of interest. Where there is insufficient language to provide clarity as to an alternate interest rate, an amendment to transaction documentation may be required.
Beyond documentation issues, there is the potential for economic implications. Some commentators have noted that LIBOR is both lower and more stable than other widely used benchmarks. Accordingly, LIBOR rates, following the implementation of reforms, may be higher, and may experience more volatility. As a result, customers of financial institutions may find themselves with higher or more volatile borrowing or hedging costs.
If the Review is accepted in full by the BBA, the British government and regulators, the recommendations are expected to start taking effect in as little as six months, with most of the changes proposed by the Review to be implemented within one year.