One Hundred and Fifty Shades of LIBOR
In the wake of the widely reported LIBOR ‘rate-rigging scandal’, the UK Government commissioned Wheatley Review of LIBOR was published in final form on 28 September 2012. It suggests a comprehensive reform of LIBOR.
In this article, we suggest that any reformed LIBOR (referred to as ‘LIBOR 2′ below) could lead to higher and more volatile lending rates, and consider what should be done now to insulate projects from any adverse consequences.
What is LIBOR?
The London Interbank Offer Rate (LIBOR) is currently used as a reference benchmark in transactions worth over $300 trillion. Although administered by the British Bankers Association (BBA), a trade association for the UK banking and financial services sector, it is currently unregulated.
On each London business day, LIBOR rates are calculated by Thompson Reuters for 15 maturities (from overnight to one year) in each of 10 currencies, i.e. there are 150 LIBOR rates. For each currency a panel of banks is asked:
‘At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am? ‘
The highest and lowest quartile of responses are discarded, and the average of the middle quartile is used to create a âshaved mean’.
Wheatley Review Recommendations
The Wheatley Review acknowledges that replacing LIBOR ‘would pose an unacceptably high risk of significant financial instability’, and instead suggests a comprehensive reform of LIBOR. In this sense LIBOR is (or at least the most widely used LIBOR rates are) likely to continue in existence. Any reform is unlikely to require, nor give parties to LIBOR based transactions the right to require, renegotiation of lending or related hedging documents.
The proposed reforms include:
Regulation: Introducing statutory regulation of LIBOR.
Introducing a New Administrator: Replacing the BBA with a new LIBOR administrator.
Use of Actual Transaction Data: Requiring submitting banks to use data from actual transactions, with individual submissions to be externally audited and published after 3 months.
Reducing Number of LIBOR benchmarks: Reducing the number of LIBOR benchmarks from 150 to 20 rates.
Encouraging Bank Participation: Giving the UK Financial Services Authority, ‘an express ‘reserve’ power to compel LIBOR submissions’.
Given the high profile of this matter in the UK and abroad, swift reforms along the lines suggested by the Review are likely. HM Treasury has stated:
‘It is the [UK] Government’s intention to respond to the review when Parliament returns [15 October], and introduce any necessary legislation in the Financial Services Bill that is currently being considered by the House of Lords.’
Structural Level of LIBOR
In standard floating LIBOR loan documentation, interest rates are set at LIBOR + Margin (+ Mandatory Costs). LIBOR is intended to compensate the lenders’ cost of funds; however, banks making LIBOR submissions are currently asked a subjective question (see above).
In relation to LIBOR’s European cousin, EURIBOR, where admittedly a slightly different question is asked of submitting banks, the Economist Newspaper recently stated:
âThe biggest banks in Italy and Spain generally estimate the cost of borrowing euros for a year at about 1.1%. This rate is much lower than the 4% and 5% their governments (and ultimate guarantors) pay to borrow for the same period. ‘¦ ‘The reference to EURIBOR is completely useless for Italian banks,’ says Giovanni Sabatini, the managing director of the Italian Banking Association. ‘EURIBOR is less than 1% and our banks are paying 350-400 basis points above EURIBOR.” [i]
At the time of writing, 3 month USD LIBOR is under 35bp. We query whether this represents the true cost of funds to banks in the interbank market, and suggest that wider margins can be used to compensate any difference between quoted LIBOR and banks’ actual cost of funds.
Assuming that any LIBOR 2 will be based on submitting banks’ actual cost of funds in the interbank market, it may well be structurally higher than existing LIBOR.
In his remarks to the European Parliament on 24 September 2012, the Chairman of the US Commodity and Futures Trading Commission, Gary Gensler, asked:
‘Given that markets are volatile, why is LIBOR so stable?’
Gensler’s remarks include evidence for 14 banks, comparing each bank’s credit default swap rate (an indicator of market perception of the bank’s creditworthiness) against the same bank’s LIBOR submissions (the bank’s own estimate of its borrowing costs). Although results vary for each bank, the relatively smooth lines of LIBOR submissions for each bank are in marked contrast to, and often unperturbed by, volatility in the same bank’s CDS rates.
On the assumption given above, we believe that any LIBOR 2 will be structurally more volatile than existing LIBOR.
Many LIBOR based loan facilities will include a definition of âMarket Disruption Event’ which includes:
‘Market Disruption Event means â¦ the Agent receives notifications from a Lender or Lenders (whose participations in a Loan exceed [x] per cent. of that Loan) that the cost to it of obtaining matching deposits in the Relevant Interbank Market would be in excess of LIBOR.’
The consequence of lender(s) invoking market disruption is that for each Lender LIBOR is replaced by:
”¦ the cost to that Lender of funding its participation in that Loan from whatever source it may reasonably select’¦’.
A lender invoking market disruption on the basis of its own borrowing costs would ordinarily incur significant adverse reputational consequences; however, the introduction of any LIBOR 2 could give lenders a plausible justification for doing so. Most facility agreements will include a âyank the bank’ provision allowing borrowers to replace a lender which invokes market disruption, and these provisions will give borrowers well needed comfort during any transition to LIBOR 2.
Suggestions for Borrowers/Projects
- Review Hedging: In preparation for the possible introduction of LIBOR 2, LIBOR based Borrowers should review their interest rate hedging arrangements.
- Take Care with LIBOR Definitions: It is more important than ever that the definition of LIBOR in loan facilities precisely matches the equivalent definition in related hedging documentation.
- Discuss with Lenders: Borrowers currently negotiating facility agreements should discuss this issue with their proposed lenders. Questions to ask include whether the proposed lenders currently fund themselves at (or below) LIBOR, and what would happen if LIBOR 2 introduced a structurally higher rate?
- Prepare for Change: Borrowers may wish to review the market disruption provisions in their LIBOR based loan facilities, and consider contingencies in case the provisions are invoked. To the extent of any unhedged LIBOR based borrowing, Borrowers should stress test their models against potentially significant increases in LIBOR.
If you wish to discuss any of the issues raised in this article, do not hesitate to contact Simon Norris, Kaushik Ray, Andrew Gray or your usual contact at Trinity International LLP.
[i] ‘The Fog of Libor’, the Economist, 14 July 2012