What The Libor Saga Reveals About Overpaid Lawyers And Bankers
Libor is on the verge of becoming Bernie from Weekend at Bernie’s—a corpse being propped up for yet another day when it really should just be laid to rest. Changes in how banks fund themselves after the 2008 financial crisis gutted the type of interbank loans that undergird Libor. These changes left the benchmark inherently vulnerable to manipulation, enabling the type of scandals that came to light in 2012. This eventually led to regulatory efforts to bring about Libor’s demise. Nonetheless, the end date for widely used tenors, such as the three-month US Dollar Libor, has now been extended until 2023. Examining how this deeply flawed reference rate has managed to stave off death again and again reveals messy truths about how deals get done, and the many shortcuts dealmakers often take in the process.
To start, it’s helpful to know a little more about Libor, an acronym for the London Interbank Offered Rate. It was first used in 1969, and rapidly proliferated as a proxy for prevailing interest rates with just a sliver of credit risk tossed in. At the time, banks in London and elsewhere regularly relied on loans from other banks to fund their activities. These interbank loans were a key mechanism for redistributing liquidity within the banking system. In practice, banks would provide daily reports regarding the interest rate they would have to pay to borrow funds in a particular currency for a particular duration. An administrator would remove outliers on both sides and then average these inputs to produce Libor.
So long as interbank lending markets were robust, there was little room for banks to report anything other than their actual funding costs. But that changed after the 2008 financial crisis and subsequent reforms. Banks started to rely more heavily on secured sources of financing and on longer term financing, reducing the volume of unsecured interbank loans. As a result, there were very few market transactions underlying the borrowing rates that banks reported. The paucity of actual transactions requires banks to exercise more judgment in the process of reporting borrowing costs, and creates more wiggle room for bad behavior, such as the scandals revealed in 2012. The result was a structural problem for which there was no easy fix.
Putting numbers on these trends reveals just how great the problem had become. According to the Alternative Reference Rate Committee—the body charged with finding a replacement for USD Libor—the aggregate face value of financial assets referencing USD Libor was just shy of $200 trillion at year-end 2016. Meanwhile, the median daily volume of three-month interbank loans for the world’s largest banks was less than $1 billion. This meant that even if the pool of banks providing inputs for Libor were expanded, the volume of transactions underlying Libor would still be dwarfed by the value of transactions using it as a reference rate.
Looking back at the 2010s, it is striking is how little effort private parties invested in trying to create a more rigorous proxy for floating interest rates. Everyone knew that interbank lending had declined dramatically. The scandals exposed how the lack of actual interbank lending rendered Libor fragile and vulnerable to manipulation. Nonetheless, everyone just kept using Libor.
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Making matters worse, the lawyers and bankers putting these deals together seem to have given almost no thought to what would happen if the deep flaws in Libor actually resulted in its cessation. One of the primary roles of these dealmakers is supposed to be identifying things that could go wrong over the life of the agreement and devising appropriate contingency plans. This is why financial contracts are often so long and tedious, at least in theory.
Given the problems known to plague Libor, one might expect the dealmakers drafting loans and other agreements to have invested serious effort trying to figure out what should happen if Libor ceased to exist. Nonetheless, the actual contracts entered into suggest that minimal attention was paid to the issue even after 2012.
Many of the agreements have fallback language, but it varies across different types of instruments, even when some were being used to hedge exposures arising from others. Moreover, the fallback language is often poorly designed to accommodate a permanent end to Libor. For example, some instruments require the parties to continue using the last known Libor rate. This may make sense if Libor cannot be calculated for a few days or weeks. But if Libor is brought to an end, such a provision effectively turns a floating rate instrument into a fixed-rate instrument.
This is not the first time that well-paid lawyers have relied on inapt boilerplate in ways that have come back to haunt their clients. The most infamous example may be “pari passu” clauses—specific boilerplate regularly included in sovereign debt agreements, despite the fact that the lawyers involved often couldn’t explain what function the clauses served. As law professors Mitu Gulati and Robert Scott explain in their insightful book on the topic, lawyers and bankers continued to use these clauses even after a surprising court ruling increased the risks of doing so.
Seeking to understand why lawyers would draft agreements with a clause that introduced meaningful litigation risk and provided no obvious benefit, Gulati and Scott spent a decade reviewing 1,500 sovereign debt agreements and engaging in 200 interviews. Their findings supported their hunch that “inefficient and harmful contract provisions could persist for long periods of time, even in the most sophisticated of financial markets.” They further found there was not a simple explanation. Rather an array of factors, many grounded in the structure of big law firms, resulted far too little innovation—even when it would create meaningful value—and tended to reinforce herd behavior. The clauses warranted book-length treatment because they vividly illustrate that even sophisticated parties with a lot of money at stake will often continue to use ill-suited but familiar terms rather than designing better alternatives.
There are differences in the persistent use of Libor and the ongoing use of pari passu clauses in sovereign debt agreements. Libor’s pervasiveness facilitates efficiencies within and across organizations, the small amount of credit risk embedded in the rate makes it bank-friendly during periods of systemic distress, and it is institutionally embedded in ways that heighten the cost of shifting to a more robust alternative. Yet there are also important similarities. The foundations underlying Libor have long been shaky and suspect; yet bankers and lawyers just kept using it, and without adequate safeguards.
This is relevant now because those poorly drafted agreements that continued to rely on Libor without adequate fallback language have spurred banks and regulators to find a way to help Libor continue to hobble along. They are doing this despite saying for years that they would let Libor die at the end of 2021. Regulators remain committed to phasing out Libor, and preventing it from being included in new agreements. Nonetheless, the prospect of the litigation, uncertainty, and potential chaos that could result from allowing Libor to cease according to plan proved more than banks or regulators were ready to stomach. It was an understandable call under the circumstances, but only because the circumstances themselves are so far from ideal.
From the bankers who kept using Libor despite its infirmities to the lawyers who failed to craft adequate fallback language given those infirmities, the Libor saga raises serious questions about the role of the dealmakers involved. They knew the problems and could have made better choices. They didn’t. Those failures have resulted in significant and avoidable costs. Libor continues to live on, long past its optimal expiration date. The public and private resources now required to minimize the disruptions caused by Libor’s demise continue to grow. At some point, the dealmakers who put these transactions together—blindly following the herd and charging premium rates in process—should be held to account.