The Demise of LIBOR: How Will Financial Institutions React?

In the demise of LIBOR, what is to be the expected reactions?

With the forecasted abandonment of the interest rate benchmark LIBOR, how will financial institutions calculate a new benchmark interest rate?

The London Inter-Bank Offered Rate (LIBOR), a benchmark interest rate at which large global banks lend capital to each other, usually in the form of short-term loans, across the international market is to be discontinued by December 31st 2021. This follows the Financial Conduct Authority (FCA), a UK-headquartered regulator, declaring the mechanism as being no longer sufficiently accurate to produce reliable rates of interest. 

The FCA made clear that panel banks shall be no longer required to submit transaction data to them by December 31st 2021. Without this crucial data, the benchmark interest rate can no longer be calculated by LIBOR. This change, or rather repeal, in regulation is particularly impactful for investment in capital markets due to contracts detailing loans (including retail mortgages and consumer loans), infrastructure arrangements and purchase terms presently relying on LIBOR to be in effect after December 2021.

Regulators across the globe are anticipating the cessation of LIBOR in an attempt to circumvent the confusion that follows losing a benchmark interest rate for unsecured wholesale lending between banks. The Securities and Exchange Commission (SEC), a US based federal government agency responsible for regulating interstate commerce and protecting investors, has encouraged market participants to disclose risk-management strategies in anticipation of LIBOR’s demise. In a statement on December 30th 2019, the SEC published a public statement encouraging audit committees to address “accounting and financial reporting and any related issues associated with financial products and contracts that reference LIBOR”. In other words, the SEC prefers that audit committees document their companies' reliance on LIBOR carefully through financial reporting to better anticipate a transition from LIBOR.

As LIBOR is to be discontinued after December 31st 2021, the natural question to ask, then, concerns what solution is in place to maintain stability during the transitional period. In short, there is no conclusive answer yet. Rather, financial institutions are relying on provisional sources created regulators to anticipate the transition from LIBOR. In the United States, the Secured Overnight Financing Rate (SOFR) has been selected by the United Reference Rates Committee (ARRC) as the provisional working alternative to USD LIBOR. However, SOFR is diverges from the traditional termly rate produced by LIBOR in allowing banks to anticipate the interest on loans. This difference alone makes the transition slightly more unpredictable as banks will have to inform antsy clients abort the complex changes in interest-rate calculation. As the clients of banks traditionally favour predictability in determining interest rates on their bank loans, each difference to LIBOR (which has been in place for over 30 years) only makes lending a more risky process. 

For now, banks and clients wait in eager anticipation of a new uniform measure of interest-rate calculation to circumvent the increasing instability surrounding contractual arrangements in reliance of LIBOR that expire post-2021.

By Brighton Dube