ASSIGNMENT AND DISCUSSION Discussion Use ethical reasoning to examine the balance of trade and payments, including parity, when contemplating the financial goals of the organization, the effects of
LIBOR Mini-Case
Replacing LIBOR
1 Copyright ©2021 Thunderbird School of Global Management, Arizona State University. All rights reserved. This case was prepared by Professor Michael H. Moffett for the purpose of classroom discussion only.
[Return to reference]
Transitioning from LIBOR is like having to figure out how to re-lay the tracks of the global financial system.
—Timothy Bowler, president of ICE Benchmark Administration, “This Man Wants to Mend, Not End, Libor,” by Daniel Kruger, Wall Street Journal, May 5, 2019.
It has often been described as “the world’s most important number.” No single interest rate is more fundamental to the operation of the global financial markets than the London Interbank Offered Rate, or LIBOR. But it was now being replaced. LIBOR has been the world’s most widely used reference interest rate for more than 50 years. It is used daily in hundreds of thousands of different financial contracts, derivatives, mortgages, bank loans, and insurance agreements. But LIBOR had failed in a number of ways beginning with the multitude of crises in the United States and United Kingdom as far back as 2007, and the world’s financial leaders were now moving to replace it. That replacement process, LIBOR cessation, was actively underway. But replacing a global benchmark used in more than $350 trillion of financial contracts worldwide, essentially a global institution, was a massive undertaking.
LIBOR Defined
LIBOR is administered by the ICE Benchmark Administration (IBA) and is calculated for five different currencies: U.S. dollar (USD), Euro (EUR), British pound sterling (GBP), Japanese yen (JPY), and the Swiss franc (CHF). It is quoted for seven different maturities: overnight; one week; and 1, 2, 3, 6, and 12 months, a daily matrix of 35 different interest rate references. Prior to the IBA taking over its publication, LIBOR was for decades calculated and published by the British Bankers Association (BBA).
Each day, a panel of 16 major multinational banks was requested to submit estimated borrowing rates in the unsecured interbank market, which were then collected, massaged, and published in three steps. In the first step, the banks on the LIBOR panels would submit their estimated borrowing rates by 11:10 a.m. London time. The submissions were made directly to Thomson Reuters, which executed the process on behalf of the BBA. In the second step, Thomson Reuters discarded the lowest 25% and highest 25% of interest rates submitted. It then calculated an average rate by maturity and currency using the remaining 50% of borrowing rate quotes. In the third and final step, the BBA published the day’s LIBOR rates 20 minutes later, by 11:30 a.m. London time. The same process was used to publish LIBOR for the five currencies and seven maturities. The 3-month and 6-month maturities are the most significant maturities due to their widespread use in various loan and derivative agreements, with the dollar and the euro being the most widely used currencies.
At its core LIBOR represents interbank borrowing. Each bank surveyed daily is asked to base its LIBOR submissions on the following question:
At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 a.m. London time?
This would require the reporting of the lowest perceived rate at which a bank could actually receive funds for a specific maturity and currency. The phrase reasonable market size is intentionally vague, as typical trading transaction sizes change frequently and the value of those transactions would vary dramatically depending upon currency.
In theory this produced a daily sample of the cost of funds for the largest and most active commercial banks in the world. The values submitted by the banks surveyed by the IBA were not, however, actual transactions. They were in fact nothing other than “indications” or perceptions and were limited to the relatively small sample of banks. And they could not be termed risk-free; the rates submitted represented the cost of funds for commercial enterprises, enterprises that still possessed a core—but likely extremely small—credit risk component. The market had in fact for decades considered a core set of banks to be inherently risk-free and “on the run,” so much so that their rates were quoted as the base benchmarks reflecting little credit risk premium.
LIBOR’s Decline
The idea that my word is my LIBOR is dead.
—Mervyn King, Bank of England Governor, Press conference on Central Bank’s Financial Stability Report, 2012.
LIBOR and the interbank market had always been prone to freeze up during times of financial crisis. During the financial crisis of September 2008, for example, for weeks the market showed so little trading that banks no longer saw it as a source of overnight funds—the exact role it was supposed to play. If trading occurred at all, it was at extremely low volumes. Low volumes in turn resulted in relatively high volatility as fewer quotes and traders provided poor price discovery.
The funding structure of financial institutions had been changing dramatically over an extended period. Commercial banking institutions, depository institutions, were required to hold more reserves, in turn requiring less overnight lending and borrowing activity, to support their balance sheets. And as many of the distinctions and regulations separating commercial banking and investment banking disappeared, investment banking firms played a greater role in markets. One such role change was that investment banks and similar financial institutions looked to the repo market for short-term funds. A repo or repurchase agreement combines the simultaneous sale and repurchase of a security (typically a government security such as a Treasury bill) as a form of short-term borrowing. The seller sells the underlying security to a buyer and by agreement buys that security back shortly afterward, usually the following day, at a slightly higher price. This difference in price is the cost of short-term funds.
Beginning in 2012 another series of troubling events eroded much of the faith in LIBOR. A series of scandals uncovered manipulation in rate quotes to the BBA. On a number of occasions, it was discovered that banks—including Barclays, one of the oldest and most esteemed banking houses in the world—were submitting interbank quotes to the BBA working cooperatively with other banks to push LIBOR rates quoted in one direction or another, sometimes by 30 or 40 basis points, for both personal and institutional gain. Quotes did not realistically represent the cost of funds for the banks in the market.
LIBOR also suffered from certain behavioral risks, particularly during crisis. One example can be found in the concerns of banks in the interbank market in September 2008 when the credit crisis was in full bloom. When a bank reported that it was being charged a higher rate by other banks, it was effectively self-reporting the market’s assessment that it was increasingly risky. In the words of one analyst, it was akin “to hanging a sign around one’s neck that I am carrying a contagious disease.”
Following the discovery of the fraudulent activity, LIBOR was placed under the direct regulation of the British government by the Financial Securities Act 2012, and its administration was transferred to the Intercontinental Exchange (ICE). One of the primary changes to LIBOR required by its new administrators was that it reflect actual transactions. But this proved challenging as fewer and fewer financial institutions were using interbank borrowing on a daily basis. The financial sector regulators across countries jointly began to search for a new alternative.
LIBOR Cessation
The Financial Stability Board (FSB) and Financial Stability Oversight Council (FSOC) have both publicly recognized for some time that the secular decline in wholesale unsecured term money market funding by banks poses serious structural risks for unsecured benchmarks such as ICE LIBOR (LIBOR). Although significant progress has been made in strengthening the governance and processes underlying LIBOR, the scarcity of underlying transactions poses a continuing risk of a permanent cessation of its production.
Because U.S. dollar (USD) LIBOR is used in such a large volume and broad range of financial products and contracts, the risks surrounding it pose a potential threat to the safety and soundness of individual financial institutions and to financial stability. Without advanced preparation, a sudden cessation of such a heavily used reference rate would cause considerable disruptions to and uncertainties around the large gross flows of USD LIBOR–related payments and receipts between many firms. It would also impair the normal functioning of a variety of markets, including business and consumer lending.
—“Second Report,” The Alternative Reference Rates Committee, March 2018.
LIBOR replacement efforts have been led by the Financial Stability Board (FSB), an international body of the G20 countries responsible for the oversight of the global financial system.2 In turn, each of the individual countries has led its own domestic development. In the United Kingdom, efforts have been led by the Financial Conduct Authority (FCA), a nongovernmental authority, working alongside the Prudential Regulation Authority and the Financial Policy Committee.
2 The FSB was founded in 2009 and has on occasion been described as the “fourth pillar” of global economic governance, joining the International Monetary Fund, the World Bank, and the World Trade Organization. The FSB, however, has no legal power or form, only working as an informal group of cooperation.
[Return to reference]
In the U.S. the LIBOR transition is being led by the U.S. Federal Reserve and its Alternative Reference Rates Committee (ARRC). ARRC is a group of private-industry participants convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition to a new, hopefully more dependable rate. Other transitions have largely been the responsibility of central banks—the Bank of Japan, the Swiss Central Bank, and the European Central Bank (ECB).
LIBOR cessation faces challenges financially and legally. For example, the United Kingdom, in an effort to avoid endless litigation involving the changeover, gave its regulator, the Financial Conduct Authority (FCA), the legal right to maintain a “LIBOR-like” reference rate, a “zombie-type” rate, that could be used for the most difficult of legacy contracts. Although the original time line announced was to end the publication of all LIBOR rates by December 31, 2021, this schedule was revised to allow more time.
On March 5, 2021, the final time line for LIBOR phaseout was announced.3
3 “FCA Announcement on Future Cessation and Loss of Representativeness of the LIBOR Benchmarks,” Financial Conduct Authority, March 5, 2021.
[Return to reference]
the overnight and 1, 3, 6, and 12 months USD LIBOR settings immediately following the LIBOR publication on Friday, June 30, 2023, and
all other LIBOR settings, including the 1 week and 2 months USD LIBOR settings, immediately following the LIBOR publication on Friday, December 31, 2021.
LIBOR Replacements
Exhibit A lists the replacements for LIBOR for the five currencies. Although not all of the individual new reference rates are secured (do not have an explicit security
