Last month, the UK Financial Conduct Authority (FCA) and other regulators urged banks to speed up their transition away from the London Interbank Offered Rate (Libor). That’s easier said than done, especially considering that many banks and corporates do not appear to be on the same page as regulators when it comes to Libor. And even if Libor goes away entirely, there are still questions of exactly which alternative reference rate (ARR) will be the one to truly replace it.
SURVEYING THE DAMAGE
What kicked off this push by regulators was the 2012 revelation that multiple financial institutions had manipulated the Libor rate for their own gain. “They manipulated it up or down based on what they wanted banks to think about them,” said Eric Juzenas, a director in Chatham Financial’s Global Regulatory Solutions. “They could have really undercut or really overstated their rate.”
But while this certainly looked bad for those banks and resulted in a number of investigations, fines and jail terms, measuring the actual damage this has done as a whole has proven much more difficult—and that may be why there is a question of whether moving to a new benchmark rate is truly necessary. As Juzenas noted, proving the long-term economic damages from Libor manipulation is close to impossible. “Even if I come up with a model, how do I convince a judge and jury that that model correctly captures what Libor would have been, absent manipulation?” he said.
And while some corporate end-users have relayed to Juzenas that Libor manipulation has taken a toll on them, many more have little visibility into what the impact of manipulation was. “Over the years, I’ve had one or two say to us, ‘We’ve paid x amount more than we should have paid on these bonds,” he said. “But the rest of the world doesn’t really know.”
‘ZOMBIE’ LIBOR AND THE COST OF FUNDING
Rather than focusing on manipulation, perhaps the better argument for doing away with Libor is that it may not accurately represent the cost of funding. “Our traders seem to think that long ago, Libor stopped representing the cost of funding for lenders,” Juzenas said.
There is an increasing concern that a ‘zombie Libor’ scenario could eventually exist, in which a small group of banks may continue to provide submissions for Libor past 2021, but Libor’s effectiveness as a benchmark for lending costs is questioned. However, Juzenas believes that such a scenario may already exist. “If Libor no longer represents the cost of funding, isn’t it already a zombie? Isn’t it then just a question of whether or not we believe zombies exist?” he asked.
However, using a new rate to determine the actual cost of funding will likely prove difficult as well. “That’s one of the biggest questions,” Juzenas said. “If the transition occurs over time, or the term structure isn’t really developed, then there is this question of what the cost of funding is and how you add that spread to a risk-free rate. I don’t think that anybody really knows the answer to that. And we have some preliminary concerns. If the dealers say, ‘We’re going to transition, and the spread is this much higher because our cost of funding has changed’, how do you evaluate that?”
QUESTIONS FOR TREASURERS
For treasurers, all this uncertainty around Libor complicates many of the contracts they have in place, especially considering that there is already a lack of transparency around how funding rates are calculated. Now, with contracts that go beyond 2021 potentially transitioning to new rates, treasury professionals may want to stay as flexible as possible in their fallback language. “What some of our members have done is renegotiate some of their credit lines and their five-year deals,” said Tom Hunt, CTP, director of treasury service for AFP. “They just have a placeholder saying that they’ll bilaterally agree to whatever that replacement rate is going to be; they’ll both agree to that at the time.”
Juzenas advises treasury professionals to maintain that flexibility. “We get really nervous when we see people talking about specificity in fallback language in light of the uncertainties that exist,” he said. “I can see the regulators wanting banks to have some certainty about their exposure. But on the other hand, an end-user with a substantial portfolio could take a real bath. Treasurers need to take steps to address this, including creating or maintaining flexibility in loan and derivatives documentation to accommodate uncertainty as to what the alternative rates and spread adjustments will look like.”
However, until corporate end-users know which ARR will take over from Libor, there is only so much they can do. And though the Secured Overnight Funding Rate (SOFR) in the United States and the UK’s Sterling Overnight Index Average (SONIA) may be emerging as frontrunners, many things can happen before 2022. “How much authority does the U.S. have to say that SOFR is going to be the preferred rate, when other jurisdictions have their own rates with different methodologies? It depends on who has the most political capital to say, ‘This is going to be the one,’” Hunt said.
For more insights, be sure to visit AFP's Libor Transition Guide.