Libor, one of the main interest rate benchmarks used in financial markets, determines interest rates for financial contracts worth trillions of pounds and is expected to be discontinued after end-2021.
Since the global financial crisis, activity in the markets that Libor measures has reduced. The low volume of transactions makes Libor a less reliable benchmark.
Market volatility in response to Covid-19 (as set out in the interim May Financial Stability Report and the August Financial Stability Report) highlighted Libor’s weakness and reinforced the need for financial markets to use alternative benchmarks.
During this shock to markets in March, the already limited market activity underpinning Libor reduced even further, meaning that rates were determined almost entirely by expert judgement from banks (Chart A). Libor rates — and hence costs for borrowers — rose, while Bank Rate was reduced to historically low levels, making cheaper funding available to banks (Chart B).footnote  In contrast, SONIA, the preferred alternative benchmark in sterling markets, remained closely in line with Bank Rate and the value of transactions underpinning SONIA increased from an average of £40 billion per day to over £60 billion in April.
The conditions observed in March have therefore reinforced the importance of the transition to alternative reference rates in advance of end-2021.
Both international authorities and industry working groups have been clear that transition from Libor in advance of end-2021 remains essential, and have revised plans to meet that timeline despite the temporary disruption to progress from Covid-19.
In the UK, the next key milestone is for loan products linked to alternative rates to be available from the end of September 2020, with Libor-linked products phased out by the end of March 2021. Businesses seeking new loans or refinancing should be offered products linked to robust alternative rates by their banks. We have published materials to help businesses understand these new products and any changes they may need to make.
Chart A The low number of transactions in the market that underpins Libor means the rate is largely based on expert judgement by banks
Proportion of ‘Level 1’, ‘Level 2’ and ‘Level 3’ submissions underlying three-month sterling Libor (a)
- Source: IBA.
- (a) Input data to Libor are categorised using a ‘waterfall’ with increasing levels of judgement. The waterfall can be summarised as follows:
- Level 1 is ‘transaction-based’ submissions — an average of transactions in unsecured deposits and primary issuances of commercial paper and certificates of deposit;
- Level 2 is ‘transaction-derived’ data, including information from historical transactions; and
- Level 3 is ‘expert judgement’ — where a panel bank has insufficient Level 1 or 2 transactions, it estimates the rate at which it could fund itself in the unsecured wholesale funding market, based on an approved procedure.
- See methodology.
Chart B During the Covid-19 shock to markets, Libor failed to track Bank Rate
- Sources: Bloomberg Finance L.P., ICE LIBOR and Bank calculations. See disclaimer at bottom of the page.
This post has been prepared with the help of Stefania Spiga and Alieda Moore.
This analysis was presented to the Financial Policy Committee in May 2020 and August 2020.
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See Bailey (2020).