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What is this week's blog about?
In this week’s blog, we take a look at the replacement of the London Interbank Offered Rate (LIBOR).
This is essential reading for RICS APC Property Finance & Investment candidates, as well as candidates on other pathways pursuing Property Finance & Funding as a technical competency.
It will also be of relevance to candidates advising on interest rates to be used in residual land valuations and development appraisals, as well as asset and investment managers.
What is LIBOR?
LIBOR is a benchmark interest rate reflecting the cost of short-term borrowing between global banks. It was first introduced in the 1980s by the British Bankers’ Association (BBA). It is used by around $30 trillion of financial contracts globally (Santander, 2021).
How is LIBOR calculated?
It is calculated daily by the Intercontinental Exchange (ICE) Benchmark Administrator (IBA) and is based on five currencies; the US dollar, the Euro, the British pound sterling, the Japanese yen and the Swiss franc. It also serves seven maturities; overnight/spot next, 1 week and 1, 2, 3, 6 and 12 months. This means that there are 35 different LIBOR rates in total.
Below is a diagram showing how LIBOR is calculated:
What is LIBOR currently used for?
LIBOR is used as a basis for calculating interest rates relating to mortgages, corporate loans, credit cards, student loans, interbank products (e.g. interest rate swaps, futures and options), syndicated loans, and so on.
When is LIBOR being replaced?
LIBOR is being phased out by the end of 2021, by the Bank of England and Financial Conduct Authority (FCA).
Why is LIBOR being replaced?
The global financial crisis of 2008-2009 led to a reduction of activity in the markets that LIBOR is based upon. The calculation of LIBOR also no longer meets internationally accepted principles for transparency and robustness.
What will LIBOR be replaced by?
LIBOR will be replaced by other risk free rates, such as the Sterling Overnight Index Average (SONIA) benchmark.
SONIA similarly reflects the average interest rates that banks pay to borrow sterling overnight from other financial institutions and institutional investors. The key difference with LIBOR is that SONIA is backwards looking (i.e. near risk-free with no premium for the term) rather than forward-looking (i.e. with a credit premium for bank credit risk and a liquidity premium for longer dated funds).
Below details other alternatives that will be adopted globally:
What are the implications of LIBOR being replaced?
The replacement of LIBOR with alternative rates will lead to pricing, cashflow, accounting and operational implications. This includes how ‘legacy’ contracts based on LIBOR will continue to operate and how alternative rates will replace LIBOR in new contracts. In particular, this will affect default interest clauses, other payment calculations and triggers for financial covenants.
For further information on the specific implications of the LIBOR replacement, PWC have an excellent article.
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Stay tuned for our next blog post to help build a better you.
N.b. Nothing in this article constitutes legal, professional or financial advice.