eBusiness Weekly
Business Writer
The Reserve Bank of Zimbabwe (RBZ) has directed banks to start engaging their clients in preparation for the June 2023 phase-out of the London Interbank Offered Rate (LIBOR) loan pricing system and its replacement by new pricing regimes.
Banks, borrowers and other stakeholders globally need to understand what alternative rates are available and begin to modify existing contracts that reference LIBOR pricing model.
Detailed planning will be required for the LIBOR phase-out. Failure to prepare could expose organisations to numerous risks.
For example, existing debt arrangements could convert from LIBOR to a higher or undesirable reference rate. Amendments to LIBOR-based contracts could also have an impact on earnings that might need to be reflected in financial reporting.
For more than 40 years, LIBOR was a key benchmark for setting the interest rates charged on adjustable-rate loans, mortgages and corporate debt.
Beginning June 2023, LIBOR will no longer be used to issue new loans. It is being replaced by the Secured Overnight Financing Rate (SOFR), which many experts consider a more accurate and more secure pricing benchmark.
SOFR is a benchmark that financial institutions use to price loans for businesses and consumers. The overnight financing part of its name references how SOFR sets rates for lenders: It’s based on the rates that large financial institutions pay each other for overnight loans.
“SOFR provides a robust and transparent method for determining a common benchmark rate based on observed, cleared transactions in the marketplace,” says Sam Weller, Senior Vice President and Director of Capital Markets at Bryn Mawr Trust, USA.
RBZ exchange control director, Farai Masendu, issued the directive on the need to prepare for the end of LIBOR as a reference rate in a statement to banking institutions this week.
The statement also centred on new provisions regarding the retention of foreign exchange by corporates from the proceeds of their domestic sales. Additionally, the statement also provided guidance on bank administration of external loans below and above US$20 million.
“Given the phasing out of the LIBOR as a reference rate with effect from June 2023, authorised dealers should engage their clients to adopt other reference rates such as the Secured Overnight Financing Rate, which is now in most jurisdictions,” Masendu said.
Bankers Association of Zimbabwe (BAZ) chief executive officer, Fanuel Mutogo, declined to comment on the impending development, LIBOR phase-out, only saying “that one is a complex issue”.
However, Mutogo commented on new administrative arrangement where banks will now only approach the central bank for registration of loans below US$40 million when all other processes of loan processing are done.
“The major change there is that banks will only approach the RBZ when all other processes have been completed, previously banks first had to seek the central bank’s approval before processing the loan,” he said.
Understanding LIBOR
Libor provided loan issuers with a benchmark for setting interest rates on different financial products. It was set each day by collecting estimates from up to 18 global banks on the interest rates they would charge for different loan maturities, given their outlook on local economic conditions.
The rate was calculated in five currencies: UK Pound Sterling, the Swiss Franc, the Euro, Japanese Yen and the US Dollar.
Libor was used to price adjustable-rate mortgages, asset-backed securities, municipal bonds, credit default swaps, private student loans and other types of debt. As of 2019, US$1,2 trillion worth of residential mortgage loans and US$1,3 trillion of consumer loans had been priced using Libor.
While Libor is no longer being used to price new loans, it will formally stick around until at least 2023. One-week and two-month Libor have ceased being published, while overnight, 1-month, 3-month, 6-month, and 12-month maturities will continue to be published through June 2023.
With an adjustable-rate loan, your lender sets regular periods where it makes changes to the rate you’re being charged. The lender referenced Libor when adjusting the interest rate on your loan, changing how much you pay each month.
Why Libor is ending
The use and abuse of credit default swaps (CDS) was one of the major drivers of the 2008 financial crisis. A very wide range of interrelated financial companies insured risky mortgages and other questionable financial products using CDS.
A CDS is a financial derivative that allows an investor to swap or offset their credit risk with that of another investor. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse them if the borrower defaults.
In a credit default swap contract, the buyer pays an ongoing premium similar to the payments on an insurance policy. In exchange, the seller agrees to pay the security’s value and interest payments if a default occurs.
Rates for CDS were set using Libor, and these derivative investments were used to insure against defaults on subprime mortgages.
American International Group (AIG) was the biggest player in the CDS disaster. The firm issued vast quantities of CDS on subprime mortgages and countless other financial products, like mortgage-backed securities. The crash of the real estate market in 2007, followed by the even larger market meltdown in 2008, forced AIG into bankruptcy, resulting in one of the largest government bailouts in history.
Once AIG started falling apart, it became clear that failing subprime mortgages and the securities built on top of them weren’t properly insured, many banks became reluctant to lend to each other.
Libor transmitted the crisis far and wide since every day Libor rate-setting banks estimated higher and higher interest rates. Libor rose, making loans more expensive, even as global central banks rushed to slash interest rates.
With rates on trillions of dollars of financial products soaring day after day, and fears about stunted bank lending reducing the flow of money through the economy, markets crashed. Libor was only one of the many factors that created the financial industry disasters of 2008, but its key role in transmitting the crisis to all parts of the global economy has driven many nations to seek safer alternatives.
