Why doesn’t the financial world have a solid transition plan away from the London Interbank offered rate, or Libor?
I recently asked that question in a column for American Banker’s BankThink opinion section. Because of a controversy over false reporting by banks several years ago, the U.K.’s Financial Conduct Authority decided in 2017 to phase Libor out by December 2021.
When I joined the Structured Finance Association at the beginning of the year, I expected the financial services sector to have more of a plan for dealing with the loss of one of the world’s most important interest rates. But on the whole, we are way behind schedule.
Some problems can be fixed, and solutions are underway. But legacy contracts — written when no one envisioned a world without Libor — don’t specify what happens when this benchmark rate goes away. The omission opens up the entire financial system and its consumers to a lot of anxiety, or worse.
Here’s part of what I wrote in BankThink:
The U.S. Federal Reserve, which is working hard to avert the worst-case scenarios, has endorsed the secured overnight financing rate as a replacement, but, so far, few new contracts are using it. Despite Libor’s deep flaws, it has been hard for SOFR to gain traction. Because SOFR is new, building its liquidity has been a challenge. Even more difficult to overcome is SOFR’s current lack of a term structure. There are no one-month, three-month or six-month SOFR rates. The rate changes overnight, which makes it unattractive to consumers and bond issuers.
The Federal Reserve’s alternative reference rates committee is also working to build a term curve for SOFR, but the job will be difficult until there are more SOFR debt issuances. We may not get there by December 2021.
Meanwhile, many contracts continue to use Libor, despite its likely demise.
Read the whole op-ed to learn my recommendations for how to avoid a big mess.