SMITH BRAIN TRUST – The end is near for Libor, the scandal-plagued financial benchmark formerly dubbed "the world's most important number." British regulators say they will phase out Libor, the London interbank offered rate, by the end of 2021, replacing it with a more transparent set of metrics more closely aligned with loan transactions.
The shift in financial markets is tectonic. Libor is said to underpin hundreds of trillions of dollars in loans and derivatives worldwide. Among them: mortgages, automobile loans and student debt.
The rate was created in 1986 to help banks set interest rates on giant corporate loans. It represents, in essence, an estimation of the rate at which banks might agree to lend to each other. But it came to be much more – a foundation of global finance, and a bellwether of sentiment, risk appetite and economic optimism.
In recent years, Libor has become mired in scandal, with traders at several banks caught netting huge profits by manipulating the rate up or down with false data. Traders were prosecuted and jailed; banks were fined billions of dollars.
Smith Brain Trust asked Clifford Rossi, Professor of the Practice in the finance department at the University of Maryland's Robert H. Smith School of Business, about the end of Libor.
SBT: With the impending exile of Libor, authorities will have to devise or embrace new benchmarks, and lenders may be forced to rewrite trillions of dollars' worth of contracts. What will authorities be looking for in a new benchmark? Are there rates out there that might easily rise to take Libor's place?
Rossi: Whatever replaces Libor has to have wide market acceptance, must not be disruptive to lending markets, must have significant liquidity and must be fairly correlated with Libor to reduce any market dislocations when the change occurs. There are several candidate rates that have been under consideration. Among them is the Overnight Bank Funding Rate, which is produced by the Federal Reserve Bank of New York and focuses on cost of funds of U.S. banks on Fed Funds and overnight Eurodollar deposits; a secured repo (repurchase agreement) rate, based on rates posted between banks lending or needing funds from each other; and the Overnight Indexed Swap (OIS) rate, which is what the Alternative Reference Rate Committee has recommended.
SBT: There are countless contracts, credit cards and other loans whose rates have been calibrated using Libor. What does this change mean for the future of lending?
Rossi: The impact on loan products, such as credit cards or mortgage tied to Libor should be small if implemented well. One study did find that using the OIS rate could save adjustable rate mortgage (ARM) borrowers between $25 to $45 per month. Ideally by selecting a rate that is correlated with Libor, the financial industry could help to mute any material effects brought on by the change.
SBT: Of course, since the financial crisis, Libor has come to be synonymous with scandal as well. Can you talk a little bit about the rigging crisis and the role it has played in Libor's demise and in reshaping regulation?
Rossi: The Libor rigging scandal stemmed from a number of major banks' involvement in overstating or understating their rates. (Libor is a composite of bank rates either paid or would be paid by banks lending with each other). Banks could profit from reporting different than actual rates paid and also allow them to appear more creditworthy than perhaps they really were. The scandal certainly undermined confidence in the accuracy of Libor and underscored the issues when banks work together, since there wasn't very good oversight of the Libor process by a regulator.
SBT: We now have about five years until Libor comes to its official end. What happens now? How do markets and financial institutions begin bracing for this change? And what in your mind are the risks as we go forward?
Rossi: Many significant regulatory and market changes take years of adjustment prior to their entry in the market and the same will be the case here for Libor's replacement. Firms will need to test their systems and make changes to processes and controls used to originate, price and service loans, and so a phase-in period will have to occur as banks test the process in parallel with existing systems. Some risks are that the replacement rate has some idiosyncratic effect that differs under certain market conditions that may not be evident today that causes some unsuspected adverse effect on borrowers.
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