Even though they may not know it, many global consumers have at least one loan tied to the London Interbank Offered Rate (LIBOR). Yet, LIBOR’s regulator is calling for an end to the rate by the end of 2021. Here, Franklin Templeton Fixed Income Group’s Mark Boyadjian and Reema Agarwal explain why they believe replacing LIBOR won’t be easy. They also share some concerns about the new-issue loan market as the market waits for a possible LIBOR replacement.
For decades, the financial world placed its trust in the London Interbank Offered Rate (LIBOR) as a reference interest rate for a wide range of financial instruments across the globe. The common view was LIBOR would represent the average interest rate a panel of leading London banks would charge each other for a loan. As LIBOR moves, so do the interest payments for some $350 trillion in financial securities.
However, scandals have eroded trust in LIBOR over the past five years. In 2012, regulators in the United States and Europe unveiled a plot by some banks to manipulate LIBOR for profit. By the end of 2016, 12 banks had paid about $10 billion in penalties.
Now, the UK’s Financial Conduct Authority (FCA) is calling for an end to LIBOR as a benchmark by the end of 2021. In July, the LIBOR regulator said it was concerned about the lack of liquidity in the underlying market. In addition, the FCA expressed concerns about material panel bank membership turnover.
As a result, the FCA said it expects the market to transition to an alternative benchmark in the next four years. Banks agreed to submit rates to sustain LIBOR on a voluntary—as opposed to mandatory—basis until the end of 2021 to ease the transition to a new benchmark.
LIBOR’s Uncertain Future
At this time, it’s too early to tell if the FCA’s 2021 deadline is set in stone, but we think the likelihood of LIBOR discontinuation is high. Past scandals and the lack of actual unsecured lending among banks have reduced the credibility of a LIBOR quote. At the core of the problem, in our view, is LIBOR depends on the opinions of industry insiders about what rates interbank lending should be, instead of actual trading levels.
We believe a change from LIBOR to an alternative benchmark would be significant. Global lenders use LIBOR to set interest rates for a variety of financial products, including interest rate swaps, student loans, mortgages, collateralized loan obligations (CLOs) and floating rate loans. A change would require amendments to the contracts and credit agreements, underlying trillions in global assets.
The interest rates on many of these contracts and agreements are set based on LIBOR plus a spread. If the alternative benchmark does not copy the compensation provided by LIBOR, it will likely result in a resetting of the spreads lenders charge and borrowers are willing to pay for these assets.