Reference rates are critical to the financial system. They are the benchmarks that lenders and borrowers refer to when setting the interest rates on credit. They also form the backbone of interest rate derivatives such as interest rate swaps and futures. The London Interbank Offer Rate (LIBOR) has been the reference rate for over 400 trillion USD worth of financial transactions. However, from 2017 after comments made by Andrew Bailey Chief Executive of the Financial Conduct Authority, the world has been slowly moving away from it; and it is expected that by the end of 2023 financial institutions will no longer rely on LIBOR and will have moved to risk free rates. The establishment of institutions such as the Alternative Reference Rate Committee (ARRC) and communication from development finance institutions such as World Bank on the move to risk free rates confirms the change that is happening in the financial markets.
The need for reference rates was seen between the 1970s and 1980s when new innovative financial products such as interest rate derivates started being employed by financial institutions as a way of managing interest rate risk. At the time, the Bretton Woods system had been dissolved and the world was facing a lot of uncertainty and inflation pressures. This meant that interest rate fluctuations needed to be hedged and the financial sector turned to these derivatives. For example, interest rate futures needed a good benchmark in order to be settled and the industry turned to the Bank of England to provide such a rate. Another factor that led to the increased use of Interbank Offer Rates (IBOR) as a reference rate was the syndicated loan market. It was believed that banks used deposits from the interbank market to fund their participation in these loans using the relevant currency of the loan; hence referring to the interbank rates when borrowing funds in these currencies.
Greek banker Minos Zombanaki’s arranged an 80 million USD syndicated loan based on the reported funding costs of a set of reference banks. In 1986, the British Bankers Association (BBA) took control of the rate and its administration hence becoming the London Interbank Offer Rate (LIBOR). They began formalizing the data collection for the fixings of the US dollar, British pound and Japanese Yen over various maturities and other currencies were included over time.
LIBOR is the rate at which major global banks would pay to borrow funds from each other in five different currencies that include the US dollar, British pound, Japanese Yen, Swiss franc and Euro. Each day the BBA asks 18 major banks across the globe how much they would charge other depository institutions for a short-term loan of seven different maturities that include overnight, 1 week and one, two, three, six and twelve months. Initially, BBA would ask banks the rate at which they believed interbank term deposits would be offered by one prime bank to another. However, in 1998 the question was changed to the rate at which they could borrow funds if they were to do so. The information is then filtered by throwing out the 4 highest and lowest figures across each of the maturities and getting the average of the remaining eight numbers. These rates are then published once a day at around 12:00 PM London time by the Intercontinental Exchange (ICE) Benchmark Association (IBA). This IBA has a designated panel of global banks that form part of the ICE LIBOR panel and are considered to have a significant role in the London market. Therefore, LIBOR answers the question of how much would JP Morgan Chase charge Bank of America for a one-month loan USD loan.
LIBOR is a very important reference rate as commercial, hybrid and consumer loan products reference these rates when determining the interest rate to be paid by the borrower. Financial markets believed that it was a reflection of the true market rate as it had no government interest. This was critical as markets believed government interests would be skewed towards political interest and not actual market realities. Lower LIBOR rates would mean lower interest rates for the public that would be a political agenda. Lack of government interest meant that LIBOR had formed some form of trust and therefore financial products such as individual and student loans as well as syndicated loans would be pegged on it. For example, an individual with a variable rate USD mortgage would know the monthly interest payments they are expected to make based on the 1-month USD LIBOR rate. International development finance institutions such as the World Bank use LIBOR as a reference rate on their loans. Loans disbursed under the International Bank for Reconstruction and Development (IBRD) and IDA (International Development Association) would be pegged on LIBOR rates.
Despite, the belief that LIBOR was a true reflection of the actual market rates a scandal hit the structure of LIBOR with major banks such as Barclays and UBS being suspected of having made submissions that were made to benefit them as opposed to the market. Investigations into LIBOR began in 2012 but the misrepresentations are suspected to have began in 2003 and heightened during the financial crisis.
Author: David Kageenu