The end of Libor: The biggest banking challenge
The industry is struggling to find an agreed replacement rate for interbank borrowing
On June 30, British bank NatWest sent out an arcanesounding press release — bus operator National Express had become the first company to take out a loan based on Sonia, a replacement for scandal-hit interest rate benchmark Libor.
It was billed as the first switch of thousands that British firms would make by end-2021, when the benchmark is set to be decommissioned. Four months on, NatWest’s trailblazing Sonia switch has been followed by only one other loan, when the bank struck a deal with utility South West Water on Oct. 2. The slow progress highlights the challenge banks and borrowers face as regulators attempt to end the use of Libor, a benchmark embedded in as much as $340 trillion financial contracts worldwide from home loans to complicated derivatives. Libor, once dubbed the world’s most important number, was discredited after the 2008 financial crisis when authorities in the US and Britain found traders had manipulated it to make a profit.
But replacing Libor is proving expensive and tricky with concerns that, if mishandled, it could trigger credit market confusion and waves of lawsuits, finance industry.
With no obvious alternative, some countries are adopting their own benchmarks. The United States is leading the way with a booming trade in derivatives linked to its new Sofr rate, while the European Central Bank started publishing Estr, its new interest rate benchmark, earlier this month.
In Britain, professional investors such as hedge funds and pension insurance clients are also already writing and trading derivatives contracts linked to Sonia. But companies which make up the so-called Libor “cash” market of sterling-denominated loans are dragging their feet or are even not aware of the shift.
At least two banks in Britain have shifted staff from teams preparing for Brexit to specialist Libor taskforces in the past quarter as the issue becomes more pressing, industry sources said.
“Part of the market is very educated and smart on this and part of the market is not even aware that Libor is going,” said Phil Lloyd, head of market structure & regulatory customer engagement at NatWest Markets. Lloyd said banks such as NatWest are battling to allay concerns among corporate borrowers that the Sonia benchmark will make it harder for them to know how much interest they owe since the rate is backward looking.
Sonia, the sterling
overnight index average, is based on the average of interest rates banks pay to borrow sterling from one another outside market hours, and is published at 9:00 a.m. local time (0800 GMT) daily, after the transactions have been vetted by the Bank of England. Borrowers taking out Sonia loans will not know exactly how much interest they owe until they are required to pay.
In contrast, loans linked to Libor can have forward-looking term rates — borrowers have greater certainty over their future liabilities to manage cash flows more easily. Bankers and consultants said the market was exploring a forward-looking Sonia term rate by mid-2020 to appease borrowers but not everyone is in favor.
The overnight Sonia rate, based on actual transactions, is seen as more robust and less vulnerable to the kind of manipulation that affected Libor, which was based on rates submitted by banks.
In the Libor rigging scandal major banks were fined billions of dollars and traders were jailed for manipulating the benchmark for profit. Some fear the creation of a Sonia term rate, which would likely be based on forward-looking estimates from banks as opposed to past transactions, could undermine the security of the benchmark and even spawn legal dangers for banks. Murray Longton, a consultant at Capco who advises financial firms on Libor transition, said banks were fearful of lawsuits, as the proliferation of alternative Sonia term rates
Name: Secured Overnight Financing Rate (Sofr)
Progress: Launched in mid-2018, trading in derivatives such as offered by different lenders could spark allegations of mis-selling.
“If you get this wrong, this is PPI for investment banking — if you haven’t communicated properly and you move a customer (on to Sonia) and benefit, there could be a case where this gets reviewed and you owe your client a lot,” he said. The Payment Protection Insurance (PPI) scandal in Britain has cost banks more than £43 billion ($52 billion) in compensation after the contracts were retrospectively deemed to have been mis-sold.
The reluctance of corporate borrowers to buy into Sonia is not the only reason for the slow progress. Banks face large costs for adapting systems and educating thousands of relationship managers on the merits of Sonia over Libor. Fourteen of the world’s top banks expect to spend more than $1.2 billion on the Libor transition, data from consultant Oliver Wyman show, with the costs for the industry as a whole set to be several times that sum.
Much of this cost is linked to the task of changing the terms of contracts tied to Libor whose duration extend beyond the 2021 deadline. Progress has been held up not only by nervous borrowers but also by banks in loan syndicates which may not agree on the new wording required to adapt loan agreements to the new benchmark. “You need unanimous agreement to change the baseline product, so what are the chances if you’ve got 10-15 participants (in a syndicate) that they will all agree on the same thing?” Capco’s Longton said.
Some corporate borrowers are also playing a waiting game to see whether they can benefit financially from Libor’s slow death spiral. But this could be costly, depending on the “fallback” language in contracts for their existing loans.
These fallbacks — originally designed to kick in if Libor was temporarily unavailable — usually stipulate alternative rates, such as calling other banks for a quote or using the last published Libor rate. But the fallback clauses were not designed to cope with Libor ceasing to exist indefinitely.
That could create big risks for borrowers, for example, by potentially converting a “floating rate” loan, tied to the fluctuations of Libor into a fixed-rate one.
Serge Gwynne, a partner at Oliver Wyman, said regulators could do more to help banks manage the transition from Libor, starting with much harder deadlines on when it would formally cease to exist.
“You are changing a product that has been used to create markets for a long time. You are not just taking one thing out and putting one thing in but changing the whole dynamic of how this works,” said Longton.