Why It Makes Business Sense To Move On From LIBOR - Andrew Hauser

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Thursday, June 27, 2019    /   12:15PM   /   By Andrew Hauser    / Header Image Credit: BOE / synpulse


 

Join The Revolution! Why It Makes Business Sense To Move On From LIBOR - Speech By Andrew Hauser, Executive Director, Markets, Bank Of England, Given At Risk Live 2019, London

 

In his speech, Andrew Hauser looks at the opportunities a post-LIBOR world could offer. He also sets out how the Bank of England is adapting its own operations to the use of SONIA.

 

Introduction

 

There seem to be two rather distinct themes to your conference today:

 

The first is all about opportunity, the future, things you might want to do: fintech, AI, new tools and ways of working. All symbolised by a rather inspiring yellow lightbulb icon on your agenda:

 

The second is all about the grim stuff: black swans, operational risks, or whatever else might lurk in your ‘hall of horrors’ sessions later – and the things you have to do in response.

 

I’m not 100% sure which camp this speech has been put in. But I think there’s a clue in the icon you’ve put next to my name in the programme – which is a revolutionary clenched fist…

 

In one sense I understand why I’ve been given a pugnacious icon. The programme to move the market from LIBOR to risk-free rates is a huge undertaking. Its goal is vital, and simply stated: to eliminate the profound system-wide vulnerabilities posed by LIBOR. And the deadline is clear: end-2021. But delivering it is as complex a task as any the financial sector has faced over the past decade, involving a global network of market participants and public authorities, and touching most systems, products and markets in some way.1

Small wonder then that many firms see LIBOR transition as a ‘must do’ more than a ‘want to do’.

 

But that perspective misses a key point: LIBOR is past its sell-by date – not just in risk terms, but in business terms too. It was designed to solve the problems of a very different era, when markets were far less transparent, and far less adept at packaging and repackaging risk. With the tools we have today, a post-LIBOR world offers many new and better opportunities: to meet the borrowing needs of households and firms; to allocate and manage risk; to express views on, or hedge against, the future paths of interest rates and credit risk; and to exploit new technologies. So more lightbulbs – fewer clenched fists!

 

Firms who grasp these opportunities early will have a real edge. In sterling markets, we have already seen how quickly specific instruments can switch away from LIBOR when the necessary foundations have been laid and first-line business teams then put their shoulder to the wheel. In Floating Rate Notes, sterling securitisations and large swathes of the cleared derivatives market, innovation and competition has driven a virtuous circle of rising liquidity and rising volumes. Taken together, these changes put sterling markets at the leading edge of global transition.

 

By contrast, firms that miss these opportunities risk finding themselves behind the curve: stranded with LIBOR-linked systems and obligations that are no longer fit for purpose. That risk is material – and will only grow as 2021 approaches.

 

Of course not every problem can be solved through innovation alone:

  • Some require collective, or public sector, action – and that is being co-ordinated through the market-led Working Group on Sterling Risk-Free Reference Rates here in the United Kingdom, and similar bodies overseas. The report card for that collective process reads ‘a lot achieved, a lot left to do’, as we discussed at a conference at the Bank on 5 June.2
  • And some do fall under the ‘must do’ heading for firms. To summarise the key conclusions of our first ‘Dear CEO’ exercise: you need to have identified and quantified your LIBOR-linked exposures; you need a granular transition project plan, including an identified responsible executive covered by the Senior Managers Regime (where applicable); you need to stress test that plan against the base case of LIBOR ceasing to exist at end-2021; you need to identify and manage your prudential and conduct risks; and you need to engage with the work of the relevant market working groups.3

 

But we won’t get there through compliance and risk management alone. We also need businesses – your businesses – to grab the opportunities presented by a post-LIBOR world to meet customer needs in better, safer ways. In the rest of my remarks I want to cover three main topics. First, I want to summarise the business problem LIBOR was originally designed to solve – and how the world has changed since then. Second, I want to sketch some of the opportunities that a post-LIBOR world may bring – and thus why there is a business, as well as a risk, imperative to shift. And, third, I want to explain some steps we at the Bank of England are taking to de-risk our own LIBOR-related business.

 

Join the revolution! Why it makes business sense to move on from LIBOR - speech by Andrew Hauser

 

 

Why LIBOR once made business sense – and what’s changed

 

LIBOR’s origins date back to the syndicated loan market of the late 1960s. Risky borrowers from developing or emerging markets were looking to raise large sums, in dollars, at term. But the most plausible lenders –US banks – faced two problems. First, rapidly-rising inflation and short term interest rates made it risky to fix the interest rate on such loans for the full term. And, second, caps on deposit rates under ‘Regulation Q’ made it hard for US-domiciled banks to raise the necessary funding. In their place, banks in London – often US-owned, but unencumbered by onshore borrowing limits – formed themselves into ‘syndicates’ to take slices of floating rate, dollar-denominated loans, funded by short-term, offshore dollar deposits.

 

The challenge was what rate to charge. Rates on US Treasury debt were judged too volatile, affected as they were by volatile economic policy at that time, and ‘flight to quality’ flows. And giving any one firm in the syndicate the right to pick a rate was both inequitable and hard for the borrower to police. So the rate was instead based on an average of the short-term wholesale unsecured funding rates of a set of banks in the syndicate, adjusted for outliers, and periodically updated every three or six months. There was no incentive for banks to lowball this number, dubbed the ‘London interbank offered rate’, because that would reduce their income. And competition to be in the syndicate was meant to curb excessive increases.

 

This approach to setting a floating dollar rate was so successful that its use rapidly spread to pricing marketable corporate debt in the early 1970s – and later to the eurodollar markets that sprang up, first in the form of derivatives contracts to hedge against macroeconomic volatility, and then as bank funding instruments. The latter accounted for over half of the dollar money market by the mid-1980s. Demands for a more formalised governance and data collection process led to the BBA taking on responsibility for producing LIBOR in 1986. And the rest is history…

 

I have dwelt on this story not so much for its intrinsic interest than to illustrate just how far we have come from those origins. For me, three key points stand out:

 

  • First, the early success of LIBOR led to its widespread adoption well beyond its original application. At first that posed few apparent problems, as bank funding costs moved in line with risk-free rates. But the financial crisis changed that. Market participants using capital instruments apparently unconnected to banks (for example, those issuing bonds, or seeking exposure to risk-free interest rates through derivatives) found themselves nonetheless heavily, and unexpectedly, exposed to variation in bank funding costs (Figure 1).

 

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Note: risk-free rate component based on 3-month OIS rates where available, and on an adjusted Bank Rate prior to 2001. The red area of the chart is influenced by bank funding costs, as well as liquidity and supply/demand conditions.

Source: Bloomberg data and Bank calculations

 

  • Second, LIBOR’s widespread use persisted long after the underlying market on which it was based – the short-term wholesale unsecured funding market – largely ceased to exist. The use of judgment to set term LIBOR rates – once simply a convenient tool to fill in for temporary gaps in an otherwise well-specified curve – became the norm. And it was that ‘design feature’, coupled with weak governance, and the huge stock of assets priced off LIBOR, which gave such a strong incentive for manipulation. Though governance arrangements for LIBOR have since been strengthened, the vast majority of term LIBOR rates remain largely or wholly based on judgment, reflecting the absence of any material underlying market (Figure 2).

  • Third, despite these two profound drawbacks, the informational and liquidity advantages of using a common established benchmark, coupled with the deep embedding of LIBOR in a range of systems, accounting and regulatory requirements have meant moving away from the use of LIBOR has required determination, forward-thinking and co-ordinated effort – even for those large parts of the market where it is manifestly the wrong rate to use.

 

 

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What opportunities will a post-LIBOR world offer?

 

Taken together, these three observations show why LIBOR transition is both necessary from a risk perspective and beneficial for the long-term efficiency of the financial markets, whilst also being unpopular in terms of the one-off transition costs involved. Indeed, there is a material risk that those transition costs are obscuring a clear perspective of the commercial benefits to users of moving beyond LIBOR.

 

What are those benefits? It would be brave for me as a public official to attempt anything approaching a complete answer to that question. But let me sketch three broad areas that seem important to us.

 

First, successful transition away from LIBOR in its current form will unbundle the risk-free and bank sector credit risk elements of the interest rate curve. Including compensation for banking credit risk may have made eminent sense for those syndicated loans made in the 60s and 70s, without greatly affecting variation in the level of LIBOR (as shown in Figure 1). But many LIBOR-linked instruments no longer directly involve banks, yet remain exposed to variations in the perception of bank risk seen in the past decade. That does not reflect an efficient allocation of risk in the economy, and poses material economic and distributional risks at times of stress, as we saw during the financial crisis.

 

 

Using a near risk-free benchmark, such as SONIA in sterling markets, rather than LIBOR should, amongst other things:

 

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Join the revolution! Why it makes business sense to move on from LIBOR - speech by Andrew Hauser

 

 

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