I received an email from First Bank in January prompting me about their transition from LIBOR to ARR. What is LIBOR? What is ARR? What is SOFR? What is the reason for the transition? How does it affect me?
LIBOR is an acronym for London Interbank Offered Rate. In layman terms, LIBOR is a daily average of the rates banks think they would pay to borrow funds from other banks. The rate was derived as an average rate from up to eighteen (18) global banks on the interest rates they charged on several loan maturities. This rate was widely accepted and one of the most widely used rates across the globe. It was utilized as a benchmark rate to set interest rates charged on adjustable-rate loans, mortgages, and corporate debt. The computation of LIBOR was done in five currencies: UK Pound Sterling, the Euro, the Japanese Yen, the Swiss Franc, and the U.S. Dollar.
The LIBOR is majorly phased out and replaced due to it’s role in the 2008 global financial crisis. It has been involved in several scandals over time. Effective December 31, 2021, Alternative Reference Rates (ARR) are in place to replace the LIBOR. The alternative rates vary across regions, currencies, tenors, and bases. However, the Alternative Reference Rates Committee selected the Secured Overnight Financing Rate (SOFR) to replace LIBOR as the benchmark rate in the US. SOFR is computed based on the rates United States’ financial institutions pay each other for overnight loans. SOFR is the weighted average of the rates charged on repurchase agreements which is secured by collateral.
Central banks and regulators are yet to be particular about the alternative reference rates to be adopted by financial institutions. However, the transition from LIBOR to the alternative reference rates may have a change on the dynamics of the banks’ operations.
As explained earlier, the SOFR serves as a benchmark rate to set the interest rates on loans given to business and customers. Unlike LIBOR which considers what financial institutions think they will pay on loans, SOFR considers the actual lending rates on transactions between the financial institutions which should make the SOFR more accurate, reliable, and transparent.
As a customer willing to take a loan from the bank, the adopted alternative reference rates will gradually be considered in the interest rates charged by the bank. While the transition does not guarantee higher or lower interest rates, it ensures that you get a fairer rate in respect to the financial market dynamics.
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LIBOR. (2022, January 4). FirstBank Nigeria. https://www.firstbanknigeria.com/business/financing/libor/
Marquit, M. (2021a, March 19). SOFR Is Coming: What Is The Secured Overnight Financing Rate? Forbes Advisor. https://www.forbes.com/advisor/investing/secured-overnight-financing-rate-sofr/
Marquit, M. (2021b, December 21). What Is Libor And Why Is It Being Abandoned? Forbes Advisor. https://www.forbes.com/advisor/investing/what-is-libor/