LIBOR (London Interbank Offered Rate) has been a reliable reference rate for financial institutions since the 1980s. Financial institutions worldwide have been using LIBOR as a benchmark interest rate for economic activities, such as contracting bonds, derivatives, corporate loans, and other financial instruments. They have linked contracts worth around USD 350 trillion with LIBOR, an astonishing fact. 

The LIBOR legislation will no more be in effect from 30th June 2023. Authorities have advised the financial industry to transition to new reference rates. Many financial organizations have already shifted to new reference rates in 2023.

Read on to understand how the LIBOR transition will impact the financial industry.

Understanding LIBOR and its discontinuation

Regulated by Financial Conduct Authority (FCA), LIBOR is the benchmark interest rate for financial institutions. Derivatives, loans, bonds, and other instruments have their interest rates decided by LIBOR. LIBOR depends on the interest rates submitted by a few banks to the Intercontinental Exchange. LIBOR has been a trusted benchmark for financial activities for decades. Besides traditional banks, non-banking institutions depend on LIBOR to decide the right interest rate. Over the years, many contracts have been pegged to LIBOR globally. For the same rationale, the transition away from LIBOR seems challenging. 

LIBOR was reliable until some controversies transpired in 2012. Accusations of some banks manipulating interest rates for trading benefits and submitting them to the Intercontinental Exchange became known, for which they were fined in 2012 by the regulatory authorities. Also, the credibility of LIBOR went down globally. In the past few years, the market has become less liquid, and LIBOR is no more reliable. As a result, FCA has decided to phase out LIBOR. After 2021, nobody published new interest rates. 

With LIBOR gone, financial institutions must adopt a new reference rate and renegotiate their contracts.

Understanding the LIBOR transition

FCA has already stopped publishing new rates with LIBOR no more in effect after 30th June 2023. Regulatory authorities and financial institutions have already started investigating alternative reference rates. ARRC (Alternative Reference Rates Committee) and many other regulators worldwide have recommended the Secured Overnight Financing Rate (SOFR) as the new benchmark. SOFR relies on actual transactions in the market and not some computer-assisted estimates.

Regulators are also exploring alternatives like SONIA, TONAR, and €STR to be the new benchmark. The LIBOR legislation is now gone, and financial institutions must renew their contracts according to a new reference rate. Somebody might change internal practices and technological solutions according to a new benchmark. Several financial instruments will be affected due to the discontinuation of LIBOR. Financial institutions must plan the transition from LIBOR to SOFR or any other reference rate.

Understanding the Impact of the LIBOR Transition 

The impact of the LIBOR transition is already visible in loans and mortgages. Many loans are pegged to LIBOR globally. The transition to a new reference rate will impact both lenders and borrowers. Loan contracts must be updated according to the new reference rate, adding more pressure on financial institutions. 

Homeowners might also be affected due to the LIBOR transition. Mortgages pegged to LIBOR might increase the monthly payments during the transition. In some cases, the LIBOR transition might decrease the mortgage interest rates. In any case, the paperwork for financial institutions will increase significantly.

Over the years, many derivatives have been pegged to LIBOR globally. Derivatives are primarily financial contracts needing amendments according to the new reference rate. Again, the burden will increase on financial institutions as they must renew derivatives contracts. Besides derivatives and loans, bonds are also affected due to the discontinuation of LIBOR legislation. Financial institutions must issue new bonds or amend the existing contracts according to a new reference rate.

Banks are among the entities to be affected most by the LIBOR transition. They must make more amends to their range of financial products, such as updating pricing models with a new benchmark chosen for financial activities. Also, they must renew the bank’s risk management process according to the new benchmark rate and update software solutions with new pricing models and risk assessment algorithms. 

Most financial institutions have products pegged to LIBOR on their balance sheets. Financial institutions must re-evaluate their liabilities and assets after the LIBOR transition. Banks might have to set new capital requirements, as the product pricing might change due to the LIBOR transition. In addition, employees within the financial industry must be ready to put in the extra work due to the discontinuation of LIBOR.

In Conclusion

The LIBOR legislation is obsolete. Financial institutions must adopt new reference rates. Financial institutions can outsource LIBOR transition to a reputed third party for reduced costs. Plan your LIBOR transition right away!