Episode 25 (pt. 1): Michael Whalen - Later, LIBOR
In this episode, we speak with Michael Whalen, a managing director in BRG’s Washington, DC, office. He has more than twenty-five years of experience in advising, structuring, and raising more than $20 billion in finance for capital-intensive infrastructure projects across the energy value chain and other infrastructure sectors.
In the first of two episodes with Michael, we focus on the future of LIBOR, one of the key benchmark rates in the world economy, which is set to go away in 2021. He provides a brief history of LIBOR and discusses why it’s being phased out.
Welcome to BRG's ThinkSet Podcast. I'm your host, Eddie Newland. BRG is a global consulting firm that helps leading organizations advance in three key areas: disputes and investigations, corporate finance, and strategy and operations. Headquartered in California with offices around the world, we are an integrated group of experts, industry leaders, academics, data scientists, and professionals working beyond borders and disciplines. We harness our collective expertise to deliver the inspired insights and practical strategies our clients need to stay ahead of what's next. For more information, please visit thinkBRG.com.
In this episode, we'll speak with Michael Whalen, a managing director with BRG in Washington, DC. We'll focus on the future of LIBOR, one of the key benchmark rates in the world economy, which is set to go away in 2021. In this, the first two episodes with Michael, we'll focus on a brief history of LIBOR and discuss why it's being phased out.
And with that, let's get started. Well Michael, thank you so much for joining us here on the ThinkSet Podcast. How are you today?
I'm doing fine thanks, Eddie.
Diving right in. Let's start with a brief history of LIBOR. For anyone who doesn't know what it is, can you cover the basics and a little bit of the history of where it came from?
LIBOR has been around for so long it's hard to imagine a time in which it wasn't the key floating rate benchmark, but LIBOR really came about at the time that banks really started engaging in international lending after World War 2. Specifically, it was there during the swinging ‘60s in London as banks found ways to be able to deploy overseas dollar deposits, and in order to do that, they needed to figure out a funding rate that would allow them to essentially create loans they would syndicate among themselves to be able to meet the needs of borrowers. And one of the first borrowers that took advantage of those floating rate loans was actually the pre-revolutionary government of Iran that was looking to borrow $80 million. And a US bank called Manufacturers Hanover—which is affectionately referred to as Manny Hanny, as now part of the greater JP Morgan Chase banking group—put together a club deal, and in order to put together this club deal, it needed to have an agreed benchmark that the participating lenders would use for setting interest rates to this borrower. And that's essentially the origins of LIBOR, which stands for the London Interbank Offered Rate. It was a self-regulated and self-created instrument of banks in London to be able to quote what their borrowing costs were and therefore, to be able to offer a rate base for borrowers who were seeking floating rate loans.
So the different types of people then that were looking for these loans. You mentioned the state of Iran at the time, or pre-revolutionary Iran, was looking for something that could be able to sustain this. Who were the other folks that started using it as it was developed that it came in handy for?
A lot of the corporate borrowing arrangements were then, and are certainly in the US market still now, done on a fixed-rate basis, and those are normally done as bond placements with a reference to underlying US treasury rates. The treasurers at a number of corporations—particularly in an environment in which interest rates were very high in the ‘60s and ‘70s—were hoping to take advantage of rates that were on the shorter into the yield curve and that would have the ability to float rather than being fixed for longer periods of time. So the users of LIBOR in terms of its traditional use, that for corporate floating rate borrowing, were really trying to find a way to tap into this significant pool of offshore US dollars that were not regulated by the US banking rules that were present at the time, which also limited the amount of deposit interest that banks could pay and the amount of interest that they were able to charge.
So by setting up this floating rate, they essentially made LIBOR the key benchmark in the world economy. What were the steps that it took from the ‘60s, ‘70s, through today that let it grow to become the standard bearer rate?
It's an interesting question, because LIBOR really became an organic choice of the market participants. It was never set up or designated by a special committee or by a regulator. I think that's an element that was frustrating in fact to some regulators. It really much developed out of necessity by the market participants. And if you actually understand the mechanics of how the rate then was and is now determined, we perhaps have this view that, given the importance of this type of rate, that it must be reflective of a tremendous number of transactions and calculations and reported activity but the truth of the matter is, really LIBOR was determined kind of from a souped-up version of Survey Monkey.
The people who were determining LIBOR [were] just a survey panel of reference banks who were members of the British Bankers Association who would receive every morning a survey question, basically polling them and saying, "Hey, at what rate could you borrow funds if you chose to do so and could you do so for a reasonable market size just prior to 11:00 a.m.?" And then the British Bankers Association would receive all of these submissions that would come in via survey; it would rank them from the highest to lowest; it would discard the top quartile and the bottom quartile as a means of discouraging any participants gaming the results and then it would basically average the results.
So this survey rate, which is what the submitters said it was, there was no evidence that was required relative to what this rate was. It was essentially a benchmark because the market participants agreed that it should be the benchmark rate.
What it stood for is very important. It's very relevant in the context of regulators efforts to replace the rate and that's because, at its core, LIBOR is supposed to be a wholesale rate, meaning it's not a rate necessarily that is the final rate, but it's a rate charged among market participants such as banks. It was quoted as a forward rate for a variety of interest periods overnight, one week, one month, two months, three months, six months, and twelve months. It was quoted a number of currencies. It was considered to be an unsecured rate. It was the ability of a bank to borrow funds without having to provide any security, and it was always understood to be explicitly based upon banks experts’ opinions and qualitative inputs and when they were trying to figure out what their response to the survey question would be.
So LIBOR grew out of what it was originally conceived as and then became something much more than was ever meant to be, to the point that regulators felt they needed to get a hold of it. But given its current construction, there is no way for them to really address the issues the way they wanted to. Come 2021, LIBOR will no longer exist. What are the biggest factors that led us to this point?
LIBOR was punished to a large extent, or fell victim to perhaps would be a better way of phrasing it, to its own popularity. If it were just a wholesale rate for banking-led corporate floating rate transactions, it probably would not have gotten the attention of the regulators to the extent that it did, particularly during the financial crisis.
But what did happen in 1997 is the Chicago Mercantile Exchange started trading standardized Eurodollar futures contracts, and in doing so they said, "We're going to use LIBOR as the benchmark for trading in these interest futures contracts." When that happened, essentially the rate was taken out of the hands of all of the gentlemen bankers wearing bowler hats in the city of London and really became something that was driving tremendous volume of activity in traded markets relative to interest rate derivatives.
So, therefore, there was really the creakiness of the LIBOR system, the honor system in reporting it, and its utilization. It became much more. It became the underpinning of a tremendous volume of financial transactions. It also became a benchmark for the relative health of financial institutions. If somebody was reporting a high LIBOR rate, that was perceived as an indication that that financial institution might be at risk. And that was, in fact, the concern during the financial crisis. So when the financial crisis occurred, all of the elements that the regulators were concerned about—limited observable transactions that linked to how the rate was developed as well as the potential for manipulation—really started to come under focus.
And in 2008, sort of as a precursor, the Wall Street Journal wrote an article that attracted a lot of attention that compared what banks were quoting as their wholesale cost of funding—their LIBOR quotes. And they were comparing that to other risk measures, particularly credit derivatives, and they were saying, "Look, these don't make sense, these financial institutions are saying their wholesale funding rates are low, but the credit risk derivative markets are saying that there is a reasonably high risk of credit default at those financial institutions." And that was really a trigger point for global regulator concern, that and the fact that as it came out, there was a lot of bad behavior on the part of a number of financial institutions, where it had been demonstrated and criminally prosecuted that various individuals on market trading desks had been sending email instructions on how to try and nudge LIBOR rates one direction or the other to benefit banks’ proprietary trading books.
So as we phase out then, and we're going to get into what some of the possible new replacement rates are. But when a historical benchmark like this goes away, what should organizations do to prepare? Are there any precedents that corporations can look back on as a model for what is to come?
I think to some extent regulators—particularly US regulators—were always a little bit frustrated with LIBOR because it was very much—I mean the principal US benchmark for floating interest rates was essentially completely outside the purview of the US banking regulatory authorities. In fact, even the UK regulators didn't really regulate it as a benchmark rate until after the financial crisis. So it wasn't until later that regulators really started paying attention to the extent that they did on benchmark rates and started to question whether the right principles were applied in developing these financial benchmarks.
So that all brings us to where we are now then, more than a decade after the financial crisis. In 2021, LIBOR officially goes away, it's all set to change. What was the impetus for that, and who's kind of working on the replacement now?
The driving forces are very clearly the US Federal Reserve and the UK Financial Conduct Authority. They have made it pretty clear that they want to see LIBOR phased out. So immediately during the financial crisis, the focus and the attention was ensuring the world didn't collapse. As the financial crisis began to recede, the global regulators really turned their attention to how are we going to come up with more robust improved financial benchmarks.
So in 2013, there's an organization called the International Organization of Securities Commissions, they developed a set of principles that should be used for financial benchmarks focusing on those benchmarks being linked to observable arms-length transaction. And as a result of that, in 2014 the Federal Reserve created an organization called the Alternative Reference Rate Committee, which was supposed to develop a new reference rate in compliance with these principles, which had been set up by the International Organization of Securities Commissions. Meanwhile, banks had increasingly indicated that they weren't really comfortable submitting LIBOR submissions.
Not as much upside anymore.
Yeah, well, I think [it] wasn't even in the issue of the upside. I think the issue was that they had been exposed to a tremendous amount of downside. Banks had paid by some estimates more than $320 billion in misconduct fines. Since the financial crisis, for various LIBOR related-claims of misconduct and individual bankers, a number of individual bankers had been convicted, although some of those convictions were reversed. But there was a lot of personal liability and institutional liability for the rate submission process. When you're providing expert judgment, that moves the market in such a substantial fashion you get concerned about the liability of doing that. So the UK FCA essentially, in 2017, said right now it had a voluntary agreement with LIBOR panel banks to continue to submit LIBOR rates, but that was only through the end of 2021, and it had not had to compel banks to submit LIBOR submissions, but it had certainly to lean on them to be able to do that, and it wasn't going to do so past 2021. So that worked quite nicely with the Fed’s direction and the recommendations of the alternative rate committee, reference rate committee which set out essentially a transition plan to implement the new rate before the 2021 phase out target.
Make sure to catch our next episode, where Michael talks about what a post-LIBOR world looks like and what business leaders need to know.
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I'm Eddie Newland, and thanks for listening. The views and opinions expressed in this podcast are those of the participants and do not necessarily reflect the opinions, position, or policy of Berkeley Research Group or its other employees and affiliates.