In 2017, current Bank of England governor Andrew Bailey (back then Chief Executive of the Financial Conduct Authority) gave a speech where he announced the FCA would no longer compel banks to contribute Libor quotes beyond the end of 2021. While the FCA can’t officially ‘force’ Libor to disappear, this effectively set out the end of the London Inter-Bank Offered Rate, the so-called “most important number in the world”, which has seen its fair share of controversy over the past decade or so.
Since the rigging scandal in the aftermath of the 2008 financial crisis highlighted the weaknesses of Libor, the production and publication of the benchmark rate has been overhauled, so why do the regulators want to be rid of it altogether? Put simply, it just doesn’t reflect reality. The unsecured inter-bank transactions that the rate is designed to measure are few and far between these days, so it is mostly based on guesswork (otherwise referred to as expert judgement). This does not make for a particularly robust or sustainable rate and does not accurately reflect banks’ funding costs.
Since 2017 there has been a lot of work globally between both public authorities and market participants to determine how the world moves away from Libor and importantly, what replaces it. The consensus has been to move to using observable near ‘risk free rates’ (RFRs, who doesn’t love a new acronym?) and in the UK this is SONIA, the Sterling Overnight Index Average. This does not completely rule out other rates, and indeed others may be developed for specific uses, but the market has already started using SONIA in new products, so it seems pretty certain to be the standard replacement benchmark rate. Indeed, beginning next month the Bank of England will start to publish a compounded SONIA index to “support use of the rate across a wide range of sterling products.”
Many issues have been put on hold due to the coronavirus pandemic, so what is happening with the transition away from Libor? Well, earlier this month Andrew Bailey gave another speech, this time as part of a webinar with the Federal Reserve Bank of New York, entitled “Libor: Entering the Endgame”, so this seems like an appropriate time to catch up on the issue.
Unsurprisingly, there hasn’t been a change of heart for the need to move away from Libor. Indeed, Bailey highlighted that the market volatility seen in March and April of this year only served to emphasize the long-standing weaknesses of Libor – as Bank Rate fell to a new all-time low to support the economy, Libor rates, and therefore borrowing costs, spiked upwards. Borrowers were left with immediately higher costs despite the jump in rates having little impact on banks’ own cost of funding, something that is clearly undesirable.
Although there have been some changes to the timeline of expected milestones, the overall deadline of end-2021 has not been pushed back. The Bank of England expects that all UK banks should all be offering alternatives to Libor from October this year and that no Libor-linked lending should be offered after the end of March 2021. When considering benchmark-linked loans or investments, questions should certainly be raised if they reference Libor and make no mention of what happens after 2021.
So far, the transition process has been market-led and the regulators want that to continue. However, the UK government has announced its intention to provide the FCA with more powers to bring about an orderly wind-down of Libor. This means the FCA will step in and take decisions on cases where an alternative to Libor really can’t be found or agreed upon (so-called ‘tough legacy’ positions). The overall message from Bailey was clear, that if you can transition away from Libor you should do so on terms agreed with your counterparties and make sure this is sorted out in the next 18 months.
The focus for most corporates is on their borrowing products, which often reference the rate. For local authorities this is less of a worry, as the most common borrowing sources, the PWLB and short-term inter-authority loans, have no direct link to the benchmark. A handful of more exotic LOBO loans which have Libor embedded into the T&Cs may still be outstanding and should be investigated.
Of most relevance to LA treasury departments will be investments in products such as floating-rate covered bonds, held with the major banks. The banks are well aware of the need for transition and as alluded to earlier, it has already become the norm for new issuance of these bonds to be linked to SONIA rather than Libor. There is also a need to convert existing bonds with maturities beyond 2021 to new reference rates and this has begun, with Lloyds leading the charge on covered bonds in October 2019. The “consent solicitation” process to change the reference rate was overwhelmingly approved by bondholders and since then at least seven other legacy bond contracts have been announced publicly as successfully moving from Libor to SONIA. We expect this process to continue across the market and local authorities with these investments should keep an eye out for communications from the banks.
Beyond investments and borrowing there may be other contracts, some perhaps unrelated to the finance department, that contain references to Libor. We would encourage clients to establish where all of their Libor exposures lie and check contract terms to see if they include “fallback” provisions covering what will happen when Libor is no longer available. It may well be the case that these terms will need to be amended and it would be sensible to speak to contract counterparties regarding this as soon as possible.