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Respond to risk

BY: Bernard Otabil
Interest rates set out the terms for using someone else’s money- literally

A LOT is changing in the world of interest rates. Ah, well, l am sure you may be wondering why l have set out with this bold statement because interest rates do change, anyway.  For sure, it is not the case that interest rates hold constant at all times since it is one of the most dynamic – and fluid – instruments in financial markets. 

So, hold on a few minutes for me, as l explain my “changing word of interest rates” in the unfolding paragraphs!

In fact, interest rates set out the terms for using someone else’s money- literally. What this means is that banks and other financial institutions may not necessarily give you money that they own themselves.

Normally, by the privileged positions that they occupy as financial intermediaries, banks and financial institutions are able to raise money from those with “surplus” and make it available to those who need them.

And, since there is no free lunch, those who need funds and therefore borrow money from the banks and the other financial institutions have to pay for using other people’s money. That is what the interest payment is- the cost of using funds that don’t belong to you!

Also, banks pay you for saving money with them using a rate of interest for the calculation.
What this means is that we are all affected by interest rates, one way or another, and thus must be concerned about global developments in financial markets as far as interest rates are concerned.

Governments, policymakers, individuals and enterprises all gauge financial decisions against the direction of market-dictated interest rates. Interest rates are so important that they have wider effects on the efficient functioning of any economy; and when they are too high they normally drive up the cost of production and hurt the real economy badly. You are affected by interest rates many times!

LIBOR
Today, what is changing in the world of interest rates is about a significant shift in the way international financial markets are going to apply rates moving forward. And l am referring here to the London Inter-bank Offered Rate, commonly referred to as LIBOR.

LIBOR, literally, is the basic rate of interest used in lending between banks on the London interbank market, and also used as a reference for setting the interest rate on other loans. As an interest-rate average, this globally applied reference rate is calculated using estimates submitted by the leading banks in London, and this becomes an interest rate benchmark used in financial markets.

What is changing, and perhaps for good, is that the LIBOR panels for sterling, yen, Swiss Franc, euro and the less heavily traded dollar tenors will cease at the end of 2021. “And, although the panels for more heavily used US dollar settings will stick around for a short while longer, to support legacy business, the US and UK authorities have been absolutely clear that new use of these rates must stop at the end of 2021 in line with everywhere else”, Andrew Hauser, Executive Director for Banking, Payments and Financial Resilience at Bank of England, said on December 8 in speech delivered at the Risk.Net telethon.

Emphatically he said: “LIBOR’s long career is drawing to an end. It’s time to bow out gracefully”. And: “Of course, as with any departure, there’s lots to do to ensure a smooth transition”.

The implication is that in the months ahead, there will be pushing and shoving as market participants try to sort out their positions on LIBOR-related businesses and new lending, and even currency markets.

Retirements


In the words of Hauser, “Retirements always seem far off, until they’re not” and that “LIBOR is no different”. What once seemed a distant prospect, he says, “is now very real” and that “one by one the remaining areas of uncertainty are closing”.

Hauser believes that there’s just a year left for all market participants to get three key things done, which he explains as follows:

• First, move all your new business off LIBOR as soon as possible next year – and by the end of March for sterling;
• Second, sign the ISDA protocol or make firm alternative plans; and
• Third, work hard to convert any remaining legacy contracts away from LIBOR.

Personal finances
The fact is, LIBOR has an impact on your personal finances too because it may affect how the institution that you do business with sources for funds.

Broadly, interest rate may be fixed or flexible and that when a loan facility is affected by general changes in market interest rate, say a change in base rate necessitating market rate adjustments, it means that the applied rate of interest is flexible. There are certainly advantages with both fixed and flexible interest rates and the choice of an option depends on the economic situation at a given point in time and the outlook.

Aside from the famous interest rate conundrum that we have to grapple with on a day-to-day basis (as explained above), there is another kind of rate- bank rate – which is normally what a central bank will pay to commercial banks for the reserves/money they hold in their accounts with them. In fact, the bank rate influences the interest rate commercial banks offer and charge their customers.

Thus, in calculating the cost of funds, commercial banks use the base rate as a good starting point. Central banks set the bank rate. All of these could be affected by the new market direction, and so far, all the reports from consultative meetings on the transitional arrangements point to LIBOR outliving its usefulness and therefore the need for the change. It is worth knowing the impact of these developments!

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