Treasurers around the world are preparing for the day when the interest rate indexes we have been using, in some cases since the mid-1980s, will no longer be available. More than $300 trillion of financial instruments, from adjustable rate home mortgages to credit cards to corporate loans, along with a whole book of intragroup transactions, are all priced using the London Interbank Offered Rate: Libor.
The rate began officially in the mid-1980s with its publication by the British Bankers’ Association. It is a consensus of clearing banks’ estimates of the rates with various maturities they charge for unsecured interbank loans. However, a very large edifice has been built on a foundation that lacks observable transactions.
Cracks in this edifice became alarmingly evident during the 2008 financial crisis. Interbank lending on an unsecured basis, especially in maturities beyond one month, declined drastically. Over a dozen banks ultimately paid fines to regulators for rigging their Libor submissions. In some cases, the banks sought a trading advantage; in others, they underpriced the rates to hide from the market their alarmingly high true cost of funding.
With banks fearing liability for submitting rates possibly subject to challenge for the lack of underlying market transactions, concerns have been rising that Libor quotations could collapse in a future financial crisis. Last July, Andrew Bailey, chief executive of the UK’s Financial Conduct Authority, announced his agency could not assure publication of Libor beyond the end of 2021.
The International Organization of Securities Commissions (IOSCO) presciently released principles in 1998 that called for basing interest-rate indexes based on observable transactions. Those principles became the roadmap following the financial crisis for recreating interest-rate indexes like Libor.
The first effort for the global financial markets was led by the Financial Stability Board (FSB), following its formation in April 2009 by the G20. In 2013 and 2014, the FSB established a Market Participants’ Group (FSB-MPG) that considered IOSCO-compliant interest rate indexes for the US dollar, sterling, euro, Swiss franc and Japanese yen.
As chairman of the National Association of Corporate Treasurers (NACT) in the US, it has fallen to me to advocate on behalf of the profession before legislators and regulators to insure otherwise well-intended financial market reforms do not unduly burden those of us in the real economy, who make the goods and provide the services that keep the wheels turning and the lights burning on Main Street.
I represented treasurers for the US dollar Libor analysis, which recommended an observable rate linked to US Treasury securities. Similar recommendations were made for sterling and the other currencies in the FSB-MPG report of July 2014.
In 2014, the Federal Reserve convened a new Alternative Reference Rates Committee (ARRC) with an initial membership of 15 banks to identify best practices for US alternative reference rates, best practices for contract robustness, and develop an adoption and implementation plan with an achievable timeline and metrics for success.
In 2017, the ARRC recommended a broad Treasury repo financing rate, the Secured Overnight Financing Rate (SOFR), as the interest rate index that should replace Libor. In March 2018, the ARRC was reconstituted with 27 members and, in addition to major money-centre banks, now has non-bank financial institutions and trade groups, including the NACT.
Treasurers in many cases are subject to entirely different forces in the upcoming Libor transition than are their counterparts in financial institutions. For example, treasurers must work within their businesses to identify the many internal uses of Libor for such things as assessing customers for late payments, pricing intercompany intragroup loans, determining an adjustment to an asset or corporate purchase based on changes in the targeted closing date, to name just a few.
In moving from the unsecured Libor index to the secured SOFR rate, basis adjustments will have to be provided. The G-20 has urged strictly arm’s-length pricing for intercompany loans to assure they are not being used by multinational corporations to manipulate taxable income among jurisdictions with differing tax rates.
Consider a loan from a US parent company to its subsidiary in a country with exchange and central bank controls on cross-border transactions. If the past rate had been Libor + 150 basis points, the new rate might be SOFR + 180 basis points, based on an analysis of past basis differences. The foreign tax authorities might think the US parent is using intercompany loans to increase the interest rate, reducing the taxable income and tax revenues to the foreign country’s treasury.
Explaining all this internally and negotiating with fiscal authorities across a large multinational group will be a time sink for our colleagues around the world.
When I talk with treasurers about the need to develop a Libor transition plan now, well in advance of the possible end date for Libor submissions, I often observe they are in what a grief counsellor would call the denial phase. We all must move as quickly as we can to the acceptance phase, because we could well be confronted with a blank screen one morning in the not too distant future when we look for the day’s Libor fixing.
Thomas C Deas, Jr is chairman of the NACT and a past chair of the International Group of Treasury Associations. In his treasury career, he has worked at companies including FMC Corporation, Airgas and Maritrans. He has served as a member of the FSB’s MPG and is a current representative to the US Federal Reserve’s Alternative Reference Rates Committee. Both these groups are charged with recommending changes concerning how Libor and other interest rate indexes should be determined.