There are three years left before the famous London Interbank Offered Rate (LIBOR) fades into history and taking its place will be something called the Secured overnight financing rate, or SOFR.
For those unfamiliar with LIBOR, it is the rate that banks charge each other while borrowing money. It is meant to measure short-term funding cost of banks. In summer of 2012, several big banks cited for manipulating LIBOR. It is perhaps one of the best-known blockbuster scandals off late. Since the crisis, the LIBOR really has become the rate at which banks don’t lend each other.
In 2017, the UK Financial Conduct Authority declared that LIBOR is plagued by rigging scandals is no longer viable. Also, the authority announced that the regulatory bodies are working to put together an alternative for LIBOR.
While the UK has offered the reformed Sterling Overnight Interest Average (SONIA), the US has adopted for SOFR. Both the rates are based on real transactions rather than on estimates of the rates at which banks would lend unsecured to each other. The Federal Reserve, New York began publishing SOFR in early April and has the daily volume of more than $700 billion in the underlying market.
Lessons from LIBOR
Cautionary lessons can be drawn from the mishap of LIBOR scandal. One of the important lessons that shall go a long way is that poor design or structure can be exploited if not today, tomorrow. In addition, other learning’s include the limitation of a self-regulatory framework, importance for a timely update to regulatory guidelines and need for robust controls. Lastly, the scandal also depicts the power of incentives that can drive an individual and a firm to do things that are imprudent and unethical.
Central bankers emphasized on the urgency for bankers to plan the end of LIBOR and urged financial institutions to make the transition to the new benchmark. One of the immediate requirements from the financial institutions would be to ensure that the language used in loan contracts contains fallback language outlining what rate would be used if LIBOR is not available. Thus, it would make it important for financial institutions to review language in contracts that extend beyond 2021.
As a next step, the market participant across sectors would now need to come together to identify the shortfalls as per the new guidelines and change their business practices including shifting to alternative benchmarks.