Mortgage loan

InterBank Offered Rates (IBORs) are reference rates based on the rates that banks use when they lend to each other. Reference rates act as benchmarks in the pricing of financial contracts and products, and play an essential role in a well-functioning financial market. In the coming years, IBORs (like EUR LIBOR, USD LIBOR, GBP LIBOR, CHF LIBOR etc.) will be phased out and replaced with risk-free reference rates (RFRs).

What the risk-free rates all have in common is that they are based on actual transactions and are retrospective. In addition, they lack maturities, so they have no credit risk. Taken together, these characteristics make RFRs more credible than IBORs.

But due to missing term structures these new Risk Free Reference rates are less suitable for long-term financing of private customers (like in home loans) – the interest base rate is changing each day, instead of 6- or 12 month period like in mostly used IBORs in financing private customers

Following the global financial crisis of 2007-2009, a number of deficiencies related to IBORs were identified. Specifically, the rates were based on professional assessments by the participating banks rather than on actual transactions, and the underlying transaction data was at times deficient. The use of IBORs also entailed a risk that the rate-setting process could be manipulated. Accordingly, the credibility of IBORs declined during this period. As a result, government authorities tightened their requirements for internal controls. In addition, legal penalties related to IBORs increased, and banks consequently became less willing to take responsibility for IBORs.

Demand for risk-free reference rates began to increase – from market players in general, but particularly from the derivatives market. A reform of the price-setting process was seen as imperative, and efforts to develop alternatives to IBORs were launched. An international overview of the reference rates led to the development of alternative risk-free reference rates.

The reference-rate reform is driven by the market, which means that the transition is taking place at a different pace in different countries and that the new risk-free reference rates may be defined in various ways.

The UK’s Financial Conduct Authority has announced that it will no longer compel banks to submit quotes to support the London Inter-bank Offered Rate (LIBOR) after 2021, which entails that LIBOR will be phased out after 2021.

The EU BMR, which came into full force on 1 January 2018, introduces a common framework governing administration, contribution and usage of benchmarks within the European Economic Area (EEA). It is aimed at ensuring the integrity of benchmarks used in financial contracts, financial instruments, or used to measure performance of investment funds in the EU.

It also requires that more robust fallback language exists in all relevant contracts and agreements. The purpose of fallbacks is to define the steps that will be taken to identify and agree an alternative benchmark in the event that the original benchmark ceases to be available or materially changes and what happens if an alternative cannot be agreed.