Bank of England: Libor System

Baroness Penn Excerpts

Thursday 17th November 2022 Grand Committee

[The Parliamentary Secretary, HM Treasury (Baroness Penn) (Con)]

My Lords, I thank my noble friend Lord James of Blackheath for securing this debate. I too wish him well with his recovery. I am grateful to other noble Lords for their contributions. I recognise the work my noble friend has done to raise the profile of issues relating to Libor. However, it would of course be inappropriate for me to comment on any specific cases.

As we have heard, Libor is a benchmark which seeks to reflect the rate at which banks lend to each other in wholesale markets. It has been important historically not just for how our financial services industry operates but for mortgage holders, borrowers and lenders in households and businesses across the country and internationally. At its height, approximately $400 trillion of financial contracts referenced Libor. It was published in all major currencies, including the dollar, sterling, yen, the euro and the Swiss franc, and for various time periods. As noble Lords have described, in 2012, it emerged that Libor was being manipulated for financial gain, in what became known as the Libor scandal.

To digress slightly, I want to reiterate the point that this Government’s position on financial market abuse is clear: it undermines the integrity of public markets, reduces public confidence in them and impairs the effectiveness of financial markets. Therefore, those found guilty of such an offence should be held to account.

The noble Baroness, Lady Kramer, asked whether we had a figure for the overall impact of Libor manipulation. I do not believe that we do, but the seriousness with which we took this issue and the response by the regulators and law enforcement show that, even without such a figure, we appreciate the scale of what was implied by the scandal.

I am sure we will have much more detailed debates on these issues in the forthcoming Financial Services and Markets Bill but I reassure the noble Baroness that it is a question not of deregulating the markets but of improving the regulation and having regulation that is better tailored to the UK. We have the opportunity to look at what works in this country rather than across 27 different jurisdictions. That is the spirit in which the Government are taking forward that Bill. I hope that provides some reassurance.

Following the subsequent government-commissioned Wheatley review and the establishment of the Parliamentary Commission on Banking Standards, Libor came under the regulatory jurisdiction of the FCA in 2013. This led to significant improvements to the regulation and governance of Libor. However, following the 2008 financial crisis, the ways in which banks raised short-term capital changed fundamentally. In particular, banks increasingly moved away from borrowing from other banks to fulfil funding needs. As a result, the unsecured interbank lending market, which Libor seeks to measure, became increasingly shallow.

Furthermore, in light of fundamental changes to bank capital-raising, in 2014 the G20’s Financial Stability Board declared that the continued use of Libor represented a

“serious source of … systemic risk”

and encouraged national authorities and financial institutions to move to alternative rates. In line with this transition plan, in 2017 the FCA announced that Libor would be published only until the end of 2021. Since then, the Government, the FCA and the Bank of England have worked together to support a market-led transition away from Libor.

As noble Lords in this Room will know, because the two noble Lords opposite me were here for the passage of the Financial Services Act 2021 and, unlike me, for the Critical Benchmarks (References and Administrators’ Liability) Act 2021, these gave the FCA the power to compel the production of synthetic Libor rates. I note that on the basis of the framework the wind-down of Libor is progressing well. Synthetic Libor provides for continuity of a Libor setting for up to 10 years. This is for the benefit of the contracts which have proved very difficult to transition—the tough legacy contracts; in other words, it is a safety net for tough legacy contracts.

The noble Baroness, Lady Kramer, said that synthetic Libor is no longer available. That is not quite correct. Since the end of 2021, we have seen a greater than anticipated reduction in the overall stock of Libor-referencing contracts, but synthetic Libor remains available where it is needed. The noble Lord, Lord Tunnicliffe, asked about additional steps the Treasury and regulators have taken to assist those who are unable to transition in time. The synthetic Libor rates for certain sterling and yen settings are there for the benefit of those who were unable to transition. The FCA will consider the data on remaining exposures when taking decisions on how long to continue its rates.

The noble Lord asked specifically about when a final decision on the winding-up of the synthetic three-month sterling Libor rate will be taken and how much notice will be provided. Over the summer the FCA published consultations on the future of the remaining Libor rates. In line with its requirement to consult on its decisions relating to synthetic Libor, the FCA will respond to the consultations in due course, but it understands and factors in the need to ensure that adequate notice is provided.

The synthetic rates for sterling and yen Libor seek to replicate as far as possible the economic outcomes that would have been achieved under Libor’s panel bank methodology. The FCA selected a methodology in line with the global consensus of firms and regulators, including extensive domestic consultation.

As many noble Lords will know, the synthetic sterling rate is calculated using the Bank of England’s sterling overnight index average—SONIA—which is administered by the Bank of England and, importantly, is based on approximately £60 billion worth of actual transactions of the interest rates that banks pay tomorrow, sterling overnight from other financial institutions and institutional investors each day. This means that SONIA is far more robust and resilient to any risks of manipulation, such as those seen before 2012. By imposing a synthetic methodology based on SONIA, the FCA can provide more time for certain legacy contracts to move to alternative benchmarks, thus reducing the risk of disruption.

The Libor benchmark has been globally important for many years, not just for those who work in financial services but for people across the country and around the globe. But, given the fundamental changes in global finance in the past 20 years, it has been appropriate to transition away from Libor safely and predictably. The UK is the home of Libor and has taken action to support the global, market-led transition away from it, reaffirming our commitment to being a trusted custodian of a global financial services sector.

The work of the UK authorities to encourage the transition away from Libor has been highly successful so far. For instance, of the estimated £30 trillion of sterling Libor exposures outstanding at the beginning of 2021, estimates show that less than 1% now remain on synthetic sterling Libor. I hope that that goes some way to answering the noble Lord’s question about the estimated number of unresolved cases. If we had not played the role that we did, the disorderly cessation of Libor could have presented a significant global financial stability risk because of the vast number and variety of contracts that reference it.

My noble friend Lord James asked what steps the Government are taking to ensure that the Libor system remains available. I hope that I have been clear about why the Government have taken the action they have to ensure a smooth and orderly wind-down of Libor. The Government continue to encourage transition away from Libor to more robust risk-free rates, such as the Bank of England’s SONIA. The Question also referred to the risk of the collapse of interbank lending. The interbank lending market that Libor seeks to measure is of course just one way that banks can fund themselves. Banks have a range of possible sources of funding available to them, including savers’ retail deposits and investors’ wholesale funding, as well as the banks’ capital base. As I said, the way in which banks fund themselves has fundamentally changed since 2008.

Of course, the other thing that has changed since 2008 is that the banking sector is substantially more resilient than before the financial crisis, with higher levels of capital and liquidity. This is because of reforms introduced after the financial crisis that require banks to hold more capital and reduce their reliance on short-term funding, such as interbank lending. For example, banks are now required to hold enough liquid assets to meet their projected outflows for at least the next 30 days, and to have enough funding with a maturity of greater than a year to fund their assets.

In addition, I reassure noble Lords that the Bank of England has a range of tools and facilities that can be called upon to support bank liquidity in the event of market stress, including liquidity insurance facilities, which are used to ensure that it achieves its financial stability objectives. These facilities can be called upon if banks stop lending to each other in the event of market stress.

To conclude, overall, the reforms introduced since 2008 have increased the financial stability of the system and will prevent the costs of banks failing from falling upon taxpayers. The sensible management of the wind-down of Libor is vital not only to the integrity of the UK’s markets but to the UK’s credibility internationally. We have worked closely with international partners in the approach that we have taken, and we received praise from them for that. The Government will continue to engage with regulators to ensure a smooth ultimate end to this transition and, in doing so, underline the UK’s reputation as a well-regulated and effective global financial centre.