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As if they didn’t have enough to deal with, banks are faced with a succession of serious challenges over the next two years as they face up to the reality of the end of Libor.
Firstly, they must figure out their exact exposure to the expiring benchmark with every client that they have – an eye watering task – and establish how to manage the situation. Secondly, they have to figure out how best to approach new lending based on new benchmarks. Thirdly they have to assess the impact on their own funding and capital structure. All in a little over 24 months.
The first challenge is enormous. Banks have vast books of legacy lending against Libor, much of which is long-term. Euromoney approached several banks for this article, none of which were prepared to speak to us about how things are going.
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Benedict James, |
“There is a perfectly sensible job to be done to move the market onto new rates, but sorting out the legacy is impossible,” declares Benedict James, a partner at law firm Linklaters in London who specializes in advising financial institutions on the prudential and structural regulatory landscape.
“The regulators’ job is to create financial stability, but they could create opportunistic disruption and force people back onto borrowing against the banks’ cost of funds,” he warns.
All financial contracts contain fallback language – which sets out the rate on which the contract is set in the event that the original interest rate is not available. But this wording was designed for a temporary disruption not for the complete cessation of the benchmark altogether.
In most cases, the fallback dictates the use of the most recently quoted or applied rate if, for example, Libor or Euribor is unavailable. So, investors would end up with effectively a fixed-rate instrument based on Libor or Euribor at, or close to, the end of 2021.
This is less of challenge for contracts based on Euribor because the rate will continue to be there.
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Cornelia Holthausen, |
“As long as Euribor exists there is no need to move away from existing contracts, but they will need to have fallback language embedded,” explains Cornelia Holthausen, deputy director general, market operations at the European Central Bank (ECB).
“The fallback language is not developed yet, and we are working to devise the right type of fallback language to avoid value transfer and minimize the risk of litigation. This is a core guiding principle.”
For existing lending based on Libor, of which there is a vast amount, this is more of a problem. Not just in terms of changing the rate but in terms of getting borrowers on board and keeping investors happy too. It is just an enormous task.
“For legacy loans any change to the reference rate is a refinancing and that is a three-month process,” James points out. “If, for example, it is a PFI [private finance initiative] loan you could be asking a local authority to amend the largest contract they have ever written and to waive their rights to a refinancing. And then they have to get consents on everything.
“If borrowers pay an awful lot of money to lawyers and advisers then they can sort out 50% to 70% of legacy loans, but there will still be a lot left that you can’t deal with,” he warns.
Banks would love to get out of submitting for Libor, but they have a big cost of transition. The cost of submitting for an extra year or two may be worth it if they are able to run off their legacy books – Serge Gwynne, Oliver Wyman
The challenge of getting banks, borrowers and investors all happy with new documentation on every outstanding Libor borrowing certainly looks like a big ask. And while some parties are acutely aware of the need to get going, others are not.
“We are having conversations with banks and issuers about floaters, but it is hard to get the attention of corporate treasurers on redocumenting two years in advance of the problem. They have more here-and-now concerns to deal with,” says Nigel Jenkins, managing principal at Payden & Rygel.
What is the answer? “One solution could be to have some kind of dummy Libor for legacy trades, but how many banks would submit for this?” asks James. “The less Libor there is, the less representative it will be. At this point they would really just be making it up.”
There is, however, an interesting question as to which would be the lesser of the two evils.
“Banks would love to get out of submitting for Libor, but they have a big cost of transition. The cost of submitting for an extra year or two may be worth it if they are able to run off their legacy books,” reckons Serge Gwynne, partner in Oliver Wyman’s corporate and institutional banking practice in London.
Safer?
According to CreditSights, replacement language has been necessarily vague even in recent contracts, due to thelack of clarity over alternative reference rates
. The regulators are in the process of coming up with more precise fallbacks.For the secured overnight financing rate (Sofr), the likely template will be the sum of the compounded daily Sofr over the contract period (which it has been suggested should be called ‘Safr’) and the average or median of the spread between Libor and Safr over that period. That sounds pretty precise if linguistically confusing. As ever, the real test is in getting someone to jump first.
“You can redocument existing securities by giving them a new Cusip with better economics and better fallback language. But we need a large issuer to take the first step,” says Larry Manis, portfolio manager at Payden & Rygel in Los Angeles.
The unspoken, but obvious, concern in this process is the risk of litigation – mischievous or otherwise.
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Glenn Havlicek, |
“Every loan agreement I have ever read refers to Libor or its successor rate, so if you are forced to transition there is language to contemplate that Libor isn’t there anymore. But I’m certain there will be litigation and court cases possibly all the way to the Supreme Court,” says Glenn Havlicek, chief executive and co-founder of GLMX, a financial technology firm specializing in money markets trading, liquidity management and reporting.
There is clear potential for arbitrage too. If, as outlined, current language dictates that floating rate instruments fall back to the last fixed rate prior to the end of Libor, investors that expect rates to fall can simply buy these notes and get interest rate protection for free.
“You can’t make a fallback rate that fully behaves in the same way as Libor. There is always the risk of value transfer,” warns Gwynne.
This is a situation ripe with opportunity for funds actively looking to exploit the unprecedented disruption as well. In the derivatives market it could be argued that the contract terminates if Libor doesn’t exist.
There is a perfectly sensible job to be done to move the market onto new rates, but sorting out the legacy is impossible – Benedict James, Linklaters
Funds could buy swaps that are significantly out of the money and then claim that the contract is no longer valid – and potentially get a sizeable settlement in return for their trouble. The International Swaps and Derivatives Association launched two new consultations on benchmark fallbacks in May, however, with a view to robust fallback language being in place before Libor ceases.
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Larry Manis, |
“Our exposure primarily resides in short-dated cash instruments, so we are not too concerned about potential litigation,” says Manis. “But some investors may have very directional derivative exposure that can have a large economic impact. There will be winners and losers.”
Even if they are able to persuade clients to move to new risk-free rates now, banks face a real challenge in how to price these cash instruments.
“The implications for bondholders are impossible to quantify given the uncertainties,” according to analysts at CreditSights. “Where there is a switch to an alternative benchmark, such as Sofr or Sonia [sterling overnight index average], the rate is likely to be lower than Libor, but this might be compensated by a higher spread over the benchmark.”
Take the hypothetical example of a loan that is currently priced at 100 basis points over Libor, with Libor at 85bp and Sonia at 70bp. The corporate client could insist that the margin is 100bp – and then the bank loses 15bp, which is a direct hit to the P&L.
To avoid this, the margin needs to be raised to 115bp over Sonia. But if the market enters another period of volatility the difference between Sonia and Libor could blow out; and the client will be paying significantly more than it was before.
It is clear that banks face an enormous workload to be ready for 2021 – both for their clients and for themselves. Whether or not they have, or will have, the right tools to address this task is very much open to question.
The regulators are unequivocal that they must move away from Libor, but the alternatives could increase the banks’ own risks, by making it harder for them to hedge any variability in their own cost of funding related to their credit risk.
Libor undoubtedly no longer accurately measures banks’ true cost of funding, but the true price of switching to the new alternatives will not be clear for a very long time to come.
