The Libor rate-rigging scandal has dogged the banking sector for the past six years.
Many billions of dollars have been paid out in penalties over allegations involving numerous financial institutions. Investigations into Libor rigging have been pursued by regulators and law enforcement authorities across the world.
Finally, the UK´s Financial Conduct Authority (FCA) has announced plans to ditch Libor, deeming it as “unsustainable and undesirable”.
Libor, or London Interbank Offered Rate, is the most commonly used global benchmark for the rate at which banks make short-term loans to one another.
Some 35 separate Libor rates are generated everyday across varying currencies and maturities. The most widely used of these is the three-month Libor rate in US dollars.
The FCA, however, has now called time on this money market rate. It wants Libor gone by the end of 2021 and replaced with alternative benchmarks that give a more accurate reflection of the short-term lending rates in the market.
The general reputation of Libor has been somewhat tarnished over recent years. Since the scandal was uncovered in 2012, around $9bn in penalties have been paid by major global banking names, which include the likes of Deutsche Bank, UBS, RBS and Barclays.
One of the UK-based traders who was found guilty of participating in the fraud is currently serving an 11-year jail sentence.
Regulators and prosecutors found that some individuals had sought to manipulate Libor rates to favour their trading positions.
They also found that some banks had been deliberately reporting unduly low Libor rates to make their own businesses look stronger in the midst of the financial crisis.
End of the line
In a speech last week, FCA chief executive Andrew Bailey said the regulator had decided it was the end of the line for Libor, not because of any further foul play but because interbank lending is no longer as big an activity as it once was.
“It is not only potentially unsustainable, but also undesirable, for market participants to rely indefinitely on reference rates that do not have active underlying markets to support them,” said Bailey.
According to Bailey, despite efforts to beef up the way Libor is calculated, banks are still having to use judgement to come up with the appropriate rates.
In his speech, the FCA boss gave an example where one of the Libor rates calculated each business day was created using submissions from a dozen banks, but who between them only completed 15 transactions within the corresponding currency and maturity segment during the whole of 2016.
The good news is that this indicates banks have largely ceased to fund themselves through unsecured, short-term interbank lending.
Banks more dependent on short-term interbank lending were especially exposed during the financial crisis as wholesale liquidity dried up and Libor rates rose sharply.
Understandably, given the dramatic Libor related headlines of the past six years, the banks themselves are unlikely to mourn Libor´s final demise, especially when they are still having to put their “judgement” on the line.
“Panel banks feel understandable discomfort about providing submissions based on judgements with so little actual borrowing activity against which to validate those judgements,” said Bailey.
While banks struggle to provide accurate Libor rates, the FCA head pointed out that such rates were still being used in certain countries to calculate loans for non-financial companies or even consumer borrowers.
“It is difficult to see a benefit to the corporate or retail borrower from having increased interest payments if bank credit quality declines and LIBOR rates therefore increase,” commented Bailey.
But why would banks choose to use Libor for such purposes anyway? A common reason is simply that Libor is well established. The British Bankers Association first began publishing Libor in 1986.
The FCA wants the banking industry to move towards alternative rates that are “based firmly on transactions”. In short, it aims to put a complete end to guess work in favour of a more scientific approach.
Whatever emerges as the preferred successor for Libor will be especially important for the global derivatives market.
It is estimated that the market for contracts between institutions using Libor as the reference rate in interest rate swaps is worth well over $200bn alone.
Interest rate swap contracts typically see institutions agree to exchange variable interest payments for fixed payments.
Earlier this year, a Bank of England working group proposed the adoption of the Sterling Overnight Index Average (SONIA) for use in such contracts.
The Sonia index mirrors rates of actual overnight funding deals in the wholesale money markets so should in theory meet the FCA´s criteria for reference rates to be based on actual transactions.
This of course though is a solution only for sterling denominated contracts. Then there is also the question as to what happens with contracts that are linked to Libor but run beyond 2021.
Global derivatives body, the International Swaps and Derivatives Association, said a key concern for the industry would also be whether there was sufficient liquidity around new reference rates.