LIBOR (the London Interbank Offer Rate ) will not be supported by the FCA after 2021, just a little over three years away. Trillions of dollars of assets are benchmarked against LIBOR, which is supposed to measure the cost at which banks can borrow short-term and unsecured in the London market. Given that the time for transitioning to a new benchmark is now short, the FCA wants to ensure that banks and insurers understand the risks of moving to other rates “and are taking appropriate action now”, it noted on 19 September, when it sent out a letter to the largest banks and insurers.
Read the prudential regulation letter
What is LIBOR
LIBOR is ubiquitous in financial markets but it only really came to public notice following the financial crisis. That was when the way in which it had been manipulated – sometimes to hide the true funding costs of banks (and, so, their vulnerability during the credit crunch), and sometimes to line the pockets of traders – became clear. Regulators had to act.
In 2017, both the FCA and FPC noted that the lack of active, underlying markets that would allow banks to really calculate LIBOR raised serious questions about the future sustainability of LIBOR benchmarks. That, together with the scale of contracts using LIBOR as a reference rate, and uncertainty about the legal position of those contracts if LIBOR became unavailable, led the FPC to decide that further reliance on LIBOR would be a risk to financial stability.
Importance of LIBOR
How great a risk? Paul Fisher, deputy head of the Prudential Regulation Authority (2014-16) and, prior to that, executive director for markets at the Bank of England (2009-14), outlined some of the problems in an article for “Financial World” in 2017. He said: “Ideally, to calculate a submission for a Libor rate, say for three-month US dollars, the rates from a large number of similar trades from the London interbank market should have been averaged. In fact, only a handful of trades were available, from differing markets across the globe, with intrinsic spreads between them. That sparse and diverse level of information, replicated across the submitting banks, was determining a market price used to benchmark the cost of trillions of dollars of financial assets, where a fraction of a basis point could make a huge difference to the profit and loss on an individual trader’s swap book.
Fisher points out that the efficient allocation of resources affects the welfare of all of us and calls for “more attention... to the mechanics that underpin fair and effective markets”.
The full article is in Financial World October - November Issue. Available only to subscribers.
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