Federal Reserve Vice Chair Randal Quarles issued a stern warning to banks on Monday about the necessity to stop using Libor interest rate benchmarks, saying regulators could question a firm’s “safety and soundness” if it is still using Libor in new agreements next year.
Libor is short for the London Interbank Offered Rate and has been one of the world’s most important interest benchmarks for decades, with many loan agreements and derivative prices keyed to it. The rate is arrived by asking a group of banks what they believe the interest rate would be if they were to borrow funds from other banks. There are actually several Libors for different loan maturities and currencies.
The basic idea was to give banks a benchmark to price loans against that was rooted in the price banks themselves would pay to borrow. So a loan to a big corporation might be priced at Libor plus 2 percentage points and a riskier loan would be something like Libor plus four percentage points.
In the wake of the financial crisis, it was discovered that several banks had manipulated the rates to benefit trading desks or to create a perception of financial strength. Ever since then, regulators around the globe have been cajoling banks to adopt new benchmarks—but this mostly has not worked. Now the regulators are telling banks that their time is up.
Quarles explained that the Fed’s Alternative Reference Rates Committee has discovered that Libor use has actually risen over the past few years.
Three years ago, the ARRC estimated that there were approximately $200 trillion in outstanding financial contracts using USD LIBOR as a reference rate. The ARRC also estimated that more than 80 percent of those contracts would mature by the end of this year. If market participants had stopped new use of LIBOR at that time, we would today have a considerably smaller amount of legacy LIBOR contracts. Instead, despite the warnings of the official sector concerning LIBOR, use of USD LIBOR has actually increased in the intervening years. As a result, the ARRC now estimates that there are currently almost $223 trillion in financial contracts based on USD LIBOR.
This month the U.K. Financial Conduct Authority confirmed that the final determination for most Libor rates will take place at end of this year, with just a few key dollar Libor rates allowed linger for a further 18 months. The hope is that if they stop publishing the rate, banks will have to give up using it.
“Although one might have expected that a statement from the regulator that a benchmark would stop might cause people to think twice before using it even if the exact end date were uncertain, many have kept using LIBOR,” Quarles said.
Quarles warning on Monday, given a symposium in New York, had two parts. First, they really are going to stop publishing Libor as scheduled and no one should think that the date will be postponed.
Quarls said the recent “statements from the administrator of LIBOR and FCA should erase any remaining doubts as to exactly when and whether LIBOR will end.”
And just in case anyone missed it, he repeated himself:
Adjusting to a new reality can be difficult, so let me be clear: These statements are definitive. Some may speculate that the June 2023 date could be pushed back, but IBA has now stated that it will not have sufficient panel bank submissions after this date, the FCA has officially recognized this date, and the spread adjustments under the International Swaps and Derivatives Association’s (ISDA) IBOR Fallbacks Protocol have been set accordingly.2 There is no scenario in which a panel-based USD LIBOR will continue past June 2023, and nobody should expect it to.
Quarles second point is that Fed bank supervisors are going to intensely focus on efforts by banks to get themselves unhooked from Libor.
“Market participants have had many years to prepare for the end of LIBOR, yet over the last few years they have actually increased use of LIBOR. Given the announcements of the FCA and the IBA, that must obviously change this year—that’s just the laws of physics—and the firms we supervise should be aware of the intense supervisory focus we are placing on their transition, and especially on their plans to end issuance of new contracts by year-end,” Quarles said.