LIBOR phase out

The phase-out of LIBOR

How will this phase-out impact banking and the investment community?

Many companies pay interest on variable rate loans based on LIBOR, but by 2021, LIBOR will likely be phased out.

What is LIBOR?

London Interbank Offered Rate (LIBOR) was established in the 1980s and was intended to reflect the rate at which AA-rated banks could borrow unsecured funds. The rate was originally set by some of the world’s largest banks and was equal to the average borrowing rate among those banks.

LIBOR rates are set every business day. Rates can be as short as an overnight rate and as long as a 12-month rate. In the U.S., three-month LIBOR is one of the most frequently used rates for pegging borrowing costs.

As the banking environment changed over the years for these large banks, the LIBOR benchmark became less of a market driven rate and more of an estimated rate at which banks could borrow from other banks. As the rates became more hypothetical, they became open to manipulation.

What was the LIBOR scandal?

During the financial crisis, some banks submitted low numbers to make it appear they were in better shape than they actually were. Borrowing costs can be an indication of risk – riskier borrowers tend to be charged higher rates – so the lower rates helped mask the liquidity problems that many banks were experiencing at the time. Not only did banks use the rates to mask problems, some also tried to manipulate LIBOR rates to make profits.

Since investigations began in 2012, regulators in the United States, the United Kingdom and the European Union have fined banks more than $9 billion for their participation in LIBOR-rigging schemes, according to the Council on Foreign Relations.

Why does LIBOR matter?

LIBOR rates affect us both as consumers and as investors. LIBOR is often the reference rate for many different types of loans, including:

  • adjustable-rate mortgages
  • home equity loans and lines of credit
  • auto loans
  • student loans
  • credit cards

LIBOR also plays a key role in many types of investments. Some common investments with floating coupon rates include:

  • investment-grade floating-rate notes
  • floating-rate or variable-rate preferred securities
  • bank loans

These investments tend to benefit when short-term rates are rising. The opposite is also true – when short-term rates fall, their coupon rates tend to fall as well.

What happens next?

Unfortunately, there are still many unknowns when it comes to LIBOR-linked investments.

A possible alternative to LIBOR comes from the Federal Reserve Bank of New York. The Secured Overnight Financing Rate (SOFR) addresses the shortcoming of LIBOR by using interest rates associated with repurchasing agreements. These agreements are based on real transaction and not theoretical transaction that can be easily manipulated.

Considering that the projected phase-out is still two years away, the transition to new benchmarks is likely to be orderly. FASB and the SEC are both exploring proposals for the transition to avoid disruption.

Questions?

Contact Mark Schmelzle using the information below to learn more about LIBOR.

Mark Schmelzle

Senior Vice President
Assurance Services

Mark Schmelzle leads the firm’s financial services industry team and is a member of the manufacturing and private equity teams. His practice focuses primarily on financial institutions, manufacturing/wholesale/distribution entities and private equity groups.

In the financial services and manufacturing industries, his experience includes financial statement audits, fraud investigations and other types of attest services.

In the private equity area, Mark provides a wide range of merger and acquisition services for private equity groups and their portfolio companies, including due diligence, cash flow analysis, quality of earnings review, and potential cost-savings analysis.

Schmelzle is a certified public accountant and a member of the American Institute of Certified Public Accountants, the Kansas Society of Certified Public Accountants and Young Bank Officers of Kansas. He is an alumnus of Leadership Wichita and was named one of the Wichita Business Journal’s “40 Under 40” young leaders in the community. He also serves in leadership positions for community organizations including Youth Entrepreneurs and the Wichita Aero Club.

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