Concept of Libor and its End

London Interbank Offered Rate or more commonly known as Libor was a key benchmark for setting the interest rates charged on loans, derivatives, bonds, securitisations and corporate debt for over 40 years.

But the last decade witnessed Libor in the limelight of scandals and crisis. Amid the rising concerns, the UK Financial Conduct Authority (FCA) confirmed that effective from 31 December 2021, Libor would no longer be used to issue new loans. Libor is said to be replaced by Secured Overnight Financing Rate (SOFR) and Alternative Reference Rate (ARR). ARR and SOFR are considered to be more accurate and more reliable benchmarks for debt pricing

What’s Libor?

Libor is a benchmark interest rate at which major global banks lend to each other in the cross border interbank market for short term loans. It was set each day by fetching estimates from up to 18 international banks on the interest rates they would charge for different loan maturities, given their outlook on economic conditions. The Libor was calculated on 5 currencies; The UK Pounds, the Swiss Franc, the Euro, Japanese Yen and the U.S Dollars.

How’s Libor Calculated?

Everyday,18 International Banks submit their opinion of the rates they think would pay if they had to borrow money from another bank on the interbank lending market in London. To help protect against the extreme rates that might disrupt the calculations, Intercontinental Exchange (ICE) strips out 4 highest and 4 lowest quoted rates before calculating the average.

Because Libor is based on a random submission of rates by the banks, manipulation of Libor is a fair reality. This has acted as a catalyst to many national regulators to identify alternatives to Libor.

Scandals Linked with Libor Manipulation

During the 2008 Financial Crisis, Libor worsened the economic condition due to its manipulative attribute in rate setting. Due to this issue, Libor is being phased out as loan benchmarking.

2008 Financial Crisis and Libor

The 2008 Global financial crisis was driven by many reasons. One of the major drivers was the use of credit default swaps (CDS). Several financial companies insured risky mortgages and loans using CDS. Libor was used while setting up the rates for CDS, and these derivatives were used to insure against default on mortgages.

The crash of the real estate market back in 2007 forced companies like American International Group (AIG) to file bankruptcy. AIG was one of the biggest players in the CDS disaster. The company issued hefty quantities of CDS on loans and other risky financial products. This melt down led to one of the largest government bailouts in the history of the U.S.

When the AIG crisis took place, it was evident that failing mortgages and the derivatives built on top of them were not secured efficiently and this led to many banks to withdraw from the idea of lending loans to each other. Libor rates sored up everyday. The banks started estimating the interest rates higher and higher. Loans became expensive because of the Libor rates. This happened even as the central banks started slashing interest rates.

With the debts on financial products mounting high and the fear of reduction in flow of money through the economy, the markets crashed. Libor was one of the major reasons that created the 2008 crisis. Due to the key role that Libor plays in the daily transactions, the nations had to look for a secured and reliable alternative.

Alternatives to Libor

The world is looking at SOFR as a vital replacement to Libor. In India, banks have already begun using SOFR and Sterling Overnight Index Average (SONIA) as the replacement. Union Bank of India was the first bank that announced it had started using the available alternatives to initiate lending.

SOFR is based on the rates U.S financial institutions pay each other for overnight dues. The transactions take the form of Treasury bonds repurchase agreements, commonly known as Repo agreements. They allow banks to meet the liquidity crisis and other reserve requirements, utilising Treasury bonds as collaterals. SOFR is based on the weighted averages of rates charged in these repo transactions.

The SOFR has already kicked off with effect from 1st of January 2022 with a hope and satisfaction of making the lending rates more safer and stable.

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