Libor is on the way out and bankers must stop using it or risk destabilising themselves and the financial system, Britain’s top regulator has warned.
The interest rate benchmark - which was used in trillions of dollars-worth of financial contracts but became notorious when traders tried to manipulate it for their own profits - is being replaced by a new overnight rate, Sonia.
Financiers have been told they should start using the new risk-free rate to price contracts ahead of a planned shift off Libor, short for London Interbank Offered Rate, at the end of 2021.
But Andrew Bailey, head of the Financial Conduct Authority, said too many bankers are still using the old measure.
Interest rate swaps with a notional value of around $50 trillion still use the outgoing benchmark, he said.
“There has hitherto been too much complacency about how these contracts would operate at the point Libor disappears,” Mr Bailey said, adding that some institutions have made “important progress on amending contractual documentation to reduce the risks of disruption or contract frustration”.
If companies do not either move to Sonia or put in place plans, in contracts, to adapt to Libor’s end, it could pose a risk to the stability of the financial system.
“Too many firms are not yet adequately aware. They are not yet making or planning the necessary investments in preparing systems, processes and business practices for transition,” said Mr Bailey, who is considered a leading candidate to take over as Governor of the Bank of England when Mark Carney steps down next year.
“The biggest obstacle to a smooth transition is inertia – a hope that Libor will continue, or that work on transition can be delayed or ignored. Misplaced confidence is a risk to financial stability as well as to individual firms.”
The problem is particularly urgent because Libor will not somehow become more relevant again, the regulator said.
Libor was based on the rate at which banks gave loans to other banks, providing an indicator of the prevailing market interest rate.
But the market has dried up as banks do not lend in this way any more, so the benchmark is now based on an estimate of the rate banks would offer, if they were in the market for such loans.
In addition its vulnerability to manipulation historically makes it unsuitable.
“The absence of ways to remedy the current underlying weakness in Libor – the lack of transactions, the unattractive prospect of Libor limping on with fewer panel banks, and the significant problems associated with a synthetic Libor, all lead to the same conclusion,” Mr Bailey said.
“The best option is actively to transition to alternative benchmarks. The most effective way to avoid Libor-related risk is not to write Libor-referencing business.”