Question

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Why LIBOR is replaced? What's the connection between 2008 Credit Crunch, Barclays's scandal and LIBOR replacement? Why LIBOR has biggest effects in banking industry?

Answer 1

1. Why LIBOR is replaced:

The London Interbank Offered Rate (LIBOR) is a reference rate based on the interest rates at which large banks indicate they can borrow unsecured funds from other banks at their London offices.

Although LIBOR was created to provide a reference rate for bank loans that was correlated with bank funding costs, LIBOR-based credit products have been swamped by derivatives tied to LIBOR. For example, as of 2014, the Market Participants Group on Reforming Interest Rate Benchmarks (MPG) estimated that about $22 trillion in loans are tied to Libor while $204 trillion in derivatives (notional amount), of which more than half are interest rate swaps, are tied to LIBOR (Market Participants Group (2014)).

The efforts to reform LIBOR intended initially to establish multiple alternative reference rates, or at least two: a risk-free rate and a rate that reflected bank credit risk. Public and private organizations attempted to revise LIBOR so that it could continue to serve as the risk-sensitive benchmark, but the efforts were stymied by the thinness of the underlying market for term unsecured bank borrowing. Efforts to develop LIBOR alternatives were largely thwarted by the same lack of transactions. More recently, the prospect of LIBOR panel banks dropping out by 2021 because of legal concerns has added urgency to the efforts to shift financial contracts to a more reliable benchmark. While there is at least one remaining contender for a risk-sensitive rate, questions remain about its robustness especially during periods of stress. Dollar-LIBOR reformers have focused exclusively on SOFR both because most see it as the best long-run solution and because of the need to encourage market participants to begin conversion without delay.

2. What's the connection between 2008 credit crunch, Barclay's Scandal and LIBOR Replacement

Following the crisis, significant concerns about manipulation of LIBOR arose. Manipulation included both reporting low rates to make the bank look stronger than it was and reporting false rates to profit on LIBOR-based financial products. In June 2012, the CFTC announced that it was levying a large fine against a bank on the LIBOR panel for manipulating LIBOR along with another benchmark rate based on the results of an investigation that had begun in 2008 (CFTC (2012)). Ultimately, several large institutions that were implicated payed substantial fines, and several senior bank executives, including the CEOs of two large banks, resigned.Additional controversy arose when it was revealed that the Federal Reserve Bank of New York had communicated its concerns about LIBOR manipulation to the Bank of England four years earlier, in 2008 (New York Fed (2012)).

The LIBOR scandal, which came to light in 2012, involved a scheme by bankers at many major financial institutions to manipulate the London Interbank Offered Rate (LIBOR) for the purposes of profit. The LIBOR, which is calculated daily, is supposed to reflect the interest rate that banks pay to borrow money from each other. It is also the basis for determining the rates charged on many other kinds of loans. Evidence suggested that this collusion had been going on since at least 2005, possibly earlier than 2003.

In the LIBOR scandal, some banks reported artificially low or high-interest rates to benefit their derivatives traders, undermining a major benchmark for interest rates and financial products.

Among the financial institutions that became caught up in the scandal were 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.

Concerns about the potential for LIBOR manipulation were amplified by the thinness of the market on which the reference rate was based (Gensler (2012)). For a variety of reasons, including post-crisis credit concerns and downgrades, copious liquidity provided by QE-swollen central bank balance sheets, and regulatory changes, banks have significantly reduced their short-term unsecured borrowing (Wheatley (2012a) and Schrimpf and Sushko (2019)). In 2018, the Federal Reserve Board estimated that only six or seven transactions occurred in the one- and three-month tenors (the most used tenors) at banks on the dollar LIBOR panel, with even fewer transactions at longer tenors (Quarles (2018)).

3. Why LIBOR has biggest effects in Banking Industry?

Most financial firms will be facing significant consequences from the end of 2021, when the majority of Interbank Offered Rates (IBORs) will be phased out by regulators and replaced by new alternative reference rates (ARR). With many consequences only just emerging, understanding the impact for each firm and taking the right actions will require that firms address some essential questions during a structured and cross-organizational analysis and change process under appropriate executive ownership. With a special focus on bank treasury functions, this article takes a closer look at the changes, implications, and recommended actions for firms impacted.

For more than 40 years, Interbank Offered Rates, especially the London Interbank Offered Rate (LIBOR) as well as the Euro InterBank Offered Rate (EURIBOR), have set the benchmark rate for lending on an unsecured basis, underpinning the worldwide trade in financial products from bonds and loans to derivatives and mortgage-backed securities.

However, a series of scandals has sealed the fate of the once dominant IBOR benchmark, including a group of banks being accused of manipulating their IBOR submissions during the financial crisis

The impact to banks can be classified into five main areas.

1. Business strategy for new floating rate business:

Given the fact that LIBOR will be discontinued by the end of 2021, treasurers need to think about when to start using the new ARR indices for their own business, when to start offering new ARR products to clients, when to start the transition of bank positions away from LIBORs, and how to deal with new LIBOR business prior to the end of 2021.

Generally, every new LIBOR trade increases the transition risk and efforts required and should be reviewed critically, specifically as long as no robust fallbacks are included within the legal documentation. , mortgages, and loans based upon LIBORs.

Additionally, treasurers should start reviewing the effects on each of the balance sheet positions to be able to understand the impacts and to be able to develop a strategy for the transition.

2. Pricing, valuation, and liquidity management

Changing the reference rates on existing and new issuances will significantly alter the funding profile of a bank. It cannot be assumed that all issuances can be switched at the same time and banks will run the risk of introducing funding premia. Cash flow models and liquidity risk management frameworks need to be updated to include ARR-based products.

Large impact should be expected for derivatives where the ISDA fallback is triggered. In such cases, an IBOR reference rate is replaced with an ARR, adjusted with a benchmark spread calculated from historical IBOR vs ARR spread.

Another related complexity will arise from the usage of LIBOR rates for margining of cleared trades. Clearing houses are expected to move to ARRs margining and discounting during 2020

3. Legal documentation

Impacted legal documents can be grouped into four classes:

1. Documentation such as product prospectus or marketing documentation for issuances which might need regulatory approval.
2. Contract documentation such as derivative master agreements, confirmations or collateral and clearing agreements which govern the different instruments or determine the rate that is used for calculating interest on collateral.
3. Loan and mortgage contracts with incorporated floating rate interest rate payments.
4. Documentation regarding cash and saving accounts or overdraft facilities.

Changes to these legal documents / contracts might follow a market standardized process such as the ISDA-agreements where ISDA might provide a protocol solution

4. Communication

Many parties and stakeholders need to be considered: it is not only clients and counterparties but all participants within their wider network, i.e. their clients, their counterparties, solution providers, IT providers, regulators, associations, as well as their internal and external stakeholders. This requires a good communication strategy and training of everyone who has touchpoints with the participants in the wider network of the organization.

5. Operations and technology

The impact on operations and IT infrastructure will depend on individual firms’ current setup, e.g. the degree of outsourcing and automation, but significant changes should certainly be anticipated. These relate to T+1 settlement of ARRs, new instruments, and migration of legacy contracts.