08 Dec Long Live Libor: 6 Structural Issues Complicating Libor Transition
By Don Mumma, Managing Director Risk Management, AxiomSL
Libor was never perfect. Launched by the British Bankers’ Association in 1984, the London Interbank Offered Rate became the official benchmark interest rate at which banks borrow from one another starting in 1986.
Since then, it has gone through many iterations and challenges. Most notably, of course, the benchmark was the subject of a major scandal in 2012, when it was revealed that Libor had been manipulated.
By 2017, British regulators had announced plans to phase out the benchmark by the end of 2021, starting the protracted Libor death march. Today, just over a year until Libor is supposed to be eliminated altogether, roughly $200 trillion of debt and contracts are still tied to the benchmark.
Why are financial institutions continuing to cling to Libor when it’s clear that it will soon die? In many cases, they don’t have an alternative.
Alternative Benchmark Palooza Fails to Address all Issues
That may sound like blasphemy to the countless alternative benchmark providers that have sprung into action over the last few years, such as:
- The U.S. Federal Reserve System’s Secured Overnight Financing Rate, or SOFR;
- The Bank of England’s Sterling Overnight Index Average, or Sonia;
- The Swiss Average Rate Overnight, or SARON;
- The Tokyo Overnight Average Rate, or TONAR; and
- The newly introduced European Central Bank’s Euro Short-Term Rate, or €STR.
- Tradeweb Markets LLC and Intercontinental Exchange Inc. have even introduced an alternative benchmark based on the U.S. Treasury yield curve.
To be sure, there has been no shortage of new acronyms waiting to fill Libor’s shoes. Still, despite the effort, many financial institutions are still writing new contracts pegged to Libor and many more are voicing concerns to regulators and central banks that they are going to have a hard time transitioning.
Earlier this year, a group of 10 midsized U.S. banks cosigned a letter to the Federal Reserve warning that SOFR will not work for them because of its over-reliance on Treasurys as collateral.
In Europe, financial institutions have balked at the costs associated with rewriting contracts and adapting their IT systems to comply with the €STR benchmark.
All of these comments have merit, but the real reason Libor persists in the global financial system is the fact that it has become inextricably linked to the underlying infrastructure of financial markets. So many of the underlying risk, compliance and operations management models and software that govern financial workflows are rooted in Libor.
Ahead is an outline of the top six structural issues currently keeping Libor on life support.
Why Libor Is so Entrenched
Libor didn’t earn the moniker “the world’s most important number” for nothing. As the benchmark evolved over the last 34 years, it’s been sliced and diced into multiple durations and both backward-looking and forward-looking rates that are used for everything from projecting market expectations for the cost of borrowing to the underlying benchmark for roughly $12 trillion in syndicated loans.
Financial technology also grew up around Libor, with virtually every piece of financial services software and nearly every financial model incorporating some link to the benchmark.
By contrast, the new risk-free rates such as SOFR and SONIA are primarily backward-looking and have not yet been ingrained into many compliance and risk reporting processes. Following are some of the specific areas where phasing out Libor has presented serious, ongoing challenges:
1. Impossible Interest Rate in the Banking Book Calculations
Interest rate risk in the banking book is the risk represented by adverse movements in interest rates that cause a mismatch between the rates banks set on customer loans and on deposits. If, for example, interest rates were to increase and a bank’s deposits repriced before its loans, that imbalance would result in the bank paying out more interest on deposits than it is receiving from loans.
In 2016, the Basel Committee on Banking Supervision finalized a regulatory framework to keep this from happening, whereby banks would report outcomes of interest rate shock scenarios based on both net interest income and economic value of equity methodologies.
The lynchpin to these calculations: Libor. Specifically, calculating interest rate in the banking book requires a forward-looking benchmark that allows them to hedge possible interest rate mismatches before they occur.
Relying on a backward-looking term index like SOFR would mean the banks would not be able to hedge their interest rate mismatches until there is a complete matching of interest income structure and interest expense structure. Likewise, borrowers would not know how much they will have to pay until after the interest period and investors would not know how much interest they will earn until after they earn it.
2. Capital Requirements Become Prohibitively Expensive due to Nonmodeled Risk Factors
The Fundamental Review of the Trading Book is a risk framework designed by the Basel Committee on Banking Supervision to set out rules governing the amount of capital banks must hold against market risk exposures. To determine these levels, banks using their own internal risk models must conduct back-tests that compare projected profit and loss values with value-at-risk figures.
In order to determine value at risk, financial institutions would need a period of statistics to determine average volatility and correlations over time. Without that history — all of which is rooted in Libor — all alternative risk-free rates would be considered nonmodeled risk factors, requiring prohibitively expensive capital requirements to offset.
3. Complex Cross-Border Derivatives Transactions That Don’t Translate
While the new crop of alternative benchmarks will work fine for most vanilla transactions, some complex instruments and transactions do not translate. For example, a cross-foreign currency derivative with maturities longer than the commencement of the alternative benchmark will be impossible to value without Libor.
What’s more, when there is variation margin required, there will be an increased risk of disputes and collateral freezes in the interim, while traders need to sort out the details on their own.
4. Lack of Credit Risk Could Provoke Volatility
Unlike Libor, the new crop of risk-free rates does not have an inherent credit risk. SOFR is based on U.S. Treasurys, SONIA and €STR are based on unsecured overnight rates. This will create increased volatility in cases where derivatives may be using two different indices. The credit riskiness between interbank offered rates has remained very stable, whereas the volatility between the secured SOFR and unsecured SONIA will introduce credit risk-induced basis price volatility.
5. Floating-Rate Loans Create Recipe for Litigation
Most syndicated-loan contracts referencing Libor do not envision the replacement of Libor with another acceptable benchmark. In most cases, they were structured so that, if Libor becomes unavailable, the benchmark rate would revert to an alternate rate determined as the higher of the federal funds rate plus a spread — typically 50 basis points — or the lead lender or administrative agent’s prime rate.
Having this much variability in the interpretation of a benchmark is a recipe for lawsuits and/or adverse legislative fixes that could harm the either the issuer/borrower or the investor/lender.
6. Unknown Credit Risk
Virtually all entities will have some level of vulnerability to adverse consequences stemming from one or more of the issues outlined above, and they have not been required to disclose, either to the public or to regulators, the magnitude nor range of possible adverse consequences. As a result, there could be stresses in liquidity if entities cut their counterparty credit limits because of these unknowns.
This issue is magnified in derivatives markets where current requirements for a standardized approach for measuring counterparty credit risk exposures include estimates of potential future exposure, which include hedging sets based on Libor reference rates. Without Libor, these add-on coefficients may not be valid and could either overstate or understate the credit risk capital charges.
Lack of Standardization Breeds Inefficiency
In each of the examples listed above, there are work-arounds and creative, stop-gap solutions that will allow financial markets to continue moving forward in the absence of Libor.
The eventual phaseout of the benchmark will not cause the market machinations to suddenly grind to a halt. Rather, it is introducing a protracted period of second-guessing and back-filling during which there will be a great deal of trial and error to get the new alternative benchmarks fit for the task.
The reason market participants — particularly those working in more complex asset classes — continue to cling to Libor is that risk models, compliance processes and operational technologies work seamlessly in the Libor world. Introducing a change — any change — to that underlying benchmark means many processes that had been on autopilot, now need to be reconfigured or reinvented.
Some, like the issues highlighted in this note will be harder to reconcile than others, but by spotlighting the challenges, we will find solutions.