Note to LIBOR: Don't call us; we'll call you.
It's complicated. Breaking up with the long-used London Interbank Offered Rate (LIBOR) standards is bittersweet. It's a benchmark that worked, until it didn't.
Technically speaking, LIBOR is a series of interest rates based on daily submissions from a panel of banks asked to report their cost to borrow funds.
To calculate the official LIBOR rate, some of the highest and lowest rates were thrown out and the rest of the rates were averaged.
"The idea was to set an interest rate based on the true cost of bank borrowing, which was a clever and effective idea," said Caleb Bigham, BOK Financial® treasurer. "This mechanism allowed banks to extend credit to borrowers while not exposing themselves to undue funding risk, which for many years benefited both borrowers and banks."
To say that LIBOR was widely adopted by the financial services sector would be an understatement. LIBOR has been a critical part of our financial system for many years and underpins everything from a $10-billion-dollar derivative trade to the rates of large corporate borrowers, and on down to the rate an average consumer pays on their credit card bill and just about everything in between. Most commonly, the average consumer knows LIBOR because of adjustable rate loans and lines of credit—like adjustable-rate mortgages, reverse mortgages, home equity lines of credit, credit cards, student loans, auto loans and any other personal loans that use the LIBOR index.
"When it comes to variable rate loans (or any loan that doesn't have a fixed interest rate), nine out of 10 are LIBOR-based," said Bigham. "Currently, there's an estimated $200 plus trillion in loans, debt, and derivatives with LIBOR-based interest rates."
While LIBOR has served the industry well for a long time, recent manipulation has driven the need for change, Bigham said.
"What we learned is that LIBOR was easily manipulated," said Bigham. "Some of the reporting banks were able to misreport numbers for their own benefit, driving up the resulting interest rates. This 'LIBOR rigging' activity ultimately resulted in various banks and financial institutions paying more than $9 billion in fines and potentially one of the largest whistleblower awards ever of $100 million to a Deutsche Bank executive who helped regulators collect information related to LIBOR rigging."
In response, the Financial Conduct Authority, or FCA, issued a mandate to cease the use of LIBOR.
"The mandate requires lenders to stop issuing new LIBOR-based loans by the end of 2021 and sunset all LIBOR-based loans by mid-2023. For borrowers with LIBOR-based loans that will expire before the 2023 cut-off date, no action is needed. Your financial institution should be communicating with you about how this transition will affect your unique situation.
"If your current LIBOR-based loan is extended past that date, you will likely receive a lot of communication from your bank," said Bigham. "They want to talk to you about the transition and whether or not it will impact your loan's interest rate. They will have all of the necessary procedures and dates to guide you through the process."
Waiting in the wings
Instead of being locked into LIBOR, Bigham said, "We're going to an environment where there are many alternative reference rates—so from having one rate that was very ubiquitous to many choices based on the financial institution, product and unique needs of the borrower."
One such rate at the forefront is SOFR, which stands for Secure Overnight Financing Rates.
SOFR is a risk-free rate, he said, because it is calculated based on the actual cost to borrow on an overnight basis backed by U.S. Treasury securities. This stands in sharp contrast to LIBOR, which was subjective and based on very little underlying transaction data.
SOFR is based on market data and trends, which lend a level of transparency to the setting of its interest rates.
"We're moving away from a way of setting interest rates that felt very abstract and subjective, to something that is more easily understood and backed by many underlying transactions, that feels tangible," he said. "It's secure. It levels the playing field with very little vulnerability to the same weaknesses we experienced with LIBOR."