Nibor, Libor and Euribor - all IBORs, but different

Kloster, Arne; Syrstad, Olav Research Report Nibor, Libor and Euribor - all IBORs, but different Staff Memo, No. 2/2019 Provided in Cooperation with: Norges Bank, Oslo Suggested Citation: Kloster, Arne; Syrstad, Olav (2019) : Nibor, Libor and Euribor - all IBORs, but different, Staff Memo, No. 2/2019, ISBN 978-82-8379-084-9, Norges Bank, Oslo, https://hdl.handle.net/11250/2592985 This Version is available at: https://hdl.handle.net/10419/210368 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. http://creativecommons.org/licenses/by-nc-nd/4.0/deed.no STAFF MEMO Nibor, Libor and Euribor – all IBORs, but different NO. 2 | 2019 ARNE KLOSTER AND OLAV SYRSTAD 2 NORGES BANK STAFF MEMO NO. 2 | 2019 NIBOR, LIBOR AND EURIBOR – ALL IBORS, BUT DIFFERENT Staff Memos present reports and documentation written by staff members and affiliates of Norges Bank, the central bank of Norway. Views and conclusions expressed in Staff Memos should not be taken to represent the views of Norges Bank. © 2019 Norges Bank The text may be quoted or referred to, provided that due acknowledgement is given to source. ISSN 1504-2596 (online) ISBN 978-82-8379-084-9 (online) 3 NORGES BANK STAFF MEMO NO. 2 | 2019 NIBOR, LIBOR AND EURIBOR – ALL IBORS, BUT DIFFERENT Nibor, Libor and Euribor – all IBORs, but different Arne Kloster and Olav Syrstad This memo takes a closer look at what lays behind different benchmark interest rates. Particular emphasis is put on how the different practices for quotation can explain why Nibor’s risk premium has on average been higher than the premiums in USD Libor and Euribor. Key: Benchmark rates, risk premia, IBOR, FX swaps, money market. 1. Introduction “IBOR” means Inter Bank Offered Rate. These four letters are common for the term reference rates in many countries around the world. In Norway, the term reference rate is Nibor. In the euro area it is Euribor and in the US it is Libor. In general, IBORs can be decomposed into two factors: the expected average level of the short-term (overnight) rate and a risk premium. The expected average of the overnight rate is closely linked to the central bank’s key policy rate, and thus reflects expected monetary policy over the relevant horizon. The risk premium can potentially reflect several things. One element is the credit risk associated with the panel of banks quoting the rates. Another is the liquidity premium that expresses the scarcity or abundance of money market credit in that particular currency over that particular horizon. For instance, in a situation where unconventional monetary policy has supplied large amounts of reserves to the banking system, the liquidity premium in the money market will normally fall. In addition, the premium will reflect the regulatory cost associated with the money market loan. For instance, as IBOR rates refer to unsecured interbank loans, the rates should entail the cost of capital for a bank incurred by providing such a loan to another bank. The risk premium can be measured by subtracting the expected level of the overnight rate from the IBOR rate. The expected level of the overnight rate is expressed by OIS-rates. An OIS is an interest rate swap, where daily payments of a reference overnight rate (like Fed Funds or EONIA) are exchanged for a fixed rate over a certain period. The OIS-rate is the fixed leg of such a swap, and expresses the expected overnight rate over the chosen horizon. The IBOR rate and the OIS contain the same expectations about the evolution of the overnight rate. Thus, subtracting the OIS from the IBOR rate, for instance using three month maturities on both, will return a measure of the risk premium in the (three month) IBOR rate. Chart 1 4 NORGES BANK STAFF MEMO NO. 2 | 2019 NIBOR, LIBOR AND EURIBOR – ALL IBORS, BUT DIFFERENT below shows the evolution of risk premiums in three month USD Libor, Euribor and Nibor 1 since 2009. Several observations can be made. The levels are different. In some periods the risk premiums are highly correlated, in others they are not. The risk premium in Nibor has on average been substantially higher than in USD Libor and Euribor. From the beginning of 2010 throughout June 2018, the average premium in Nibor was 46 basis points. This is considerably higher than the corresponding premiums for USD Libor and Euribor, at 21 and 19 basis points respectively. Chart 1: Risk premiums in USD Libor, Euribor and Nibor. January 2010 – June 2018. Per cent. Sources: Bloomberg and Norges Bank In order to understand why the risk premiums in these three reference rates differ so much, it is necessary to understand how the respective banking panels arrive at their quotes. This is in fact quite different, meaning that these rates do not refer to the same kind of transactions, although their definitions are similar and they are all called IBOR. This memo takes a closer look at what lays behind these rates. Particular emphasis is put on how the different practices for quotation can explain why Nibor’s risk premium has on average been higher than the premiums in USD Libor and Euribor. 2. The general problem with IBORs Unsecured term interbank reference rates all have one common problem: They are meant to represent rates on transactions that are 1 As no OIS-market exists in Norway, the Nibor risk premium in Chart 1 is based on Norges Bank’s assessment of Norwegian expected overnight rates. -0,2 0 0,2 0,4 0,6 0,8 1 1,2 1,4 -0,2 0 0,2 0,4 0,6 0,8 1 1,2 1,4 2010 2011 2012 2013 2014 2015 2016 2017 2018 Euribor USD Libor Nibor 5 NORGES BANK STAFF MEMO NO. 2 | 2019 NIBOR, LIBOR AND EURIBOR – ALL IBORS, BUT DIFFERENT virtually non-existent. Available data and surveys show that unsecured interbank lending is heavily concentrated in the shortest maturities, like overnight. Very little unsecured interbank lending goes on in maturities of three and six months, see ICE (2016) 2 for the case of USD Libor and ECB (2015) for Euribor. 3 This was the case even before the financial crisis, and the trend has been reinforced since then. This means that the banks submitting IBORs must rely on rates from other markets with similar characteristics, on their subjective judgement or a combination of the two. The current effort in many countries to produce nearly riskfree alternative reference rates must be seen in this context. 3. USD Libor Since 1998, Libor has been defined by the panel banks’ daily answer to the following question: “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am?” This question is posed in a way that defines Libor as an interbank offered rate. However, recognizing the fact that interbank term transactions are rare, the administrator of Libor, ICE Benchmark Administration Limited (IBA), has laid out a roadmap for the transition of Libor to a new “waterfall methodology”. This methodology entails a new output statement for Libor: “A wholesale funding rate anchored in LIBOR panel banks’ unsecured transactions to the greatest extent possible, with a waterfall to enable a rate to be published in all market circumstances”. The term “waterfall” refers to the ordering of inputs for the submissions into three levels. To the extent available, panel banks should base their submissions on Level 1 input, which are “eligible wholesale, unsecured funding transactions”. If no such eligible transactions were made, submissions should be transaction-derived (Level 2). That means utilizing time-weighted historical eligible transactions adjusted for market movements, and linear interpolation. If neither Level 1 nor Level 2 inputs are available, panel banks should base their submissions on expert judgement (Level 3). One important feature of the new methodology is that the eligible transactions are no longer limited to interbank loans. The eligible transactions are rates paid by banks on unsecured term deposits, as well as fixed rates paid on primary issuances of commercial paper (CP) and certificates of deposits (CD). The major part of CP and CD funding comes from investors outside the banking system, like money market funds and non-financial corporations. Rates paid by banks on CP/CD 2 Roadmap for ICE LIBOR (2016) published by ICE Benchmark Administration 3 Euro Money Market Survey (2015) published by the European Central Bank 6 NORGES BANK STAFF MEMO NO. 2 | 2019 NIBOR, LIBOR AND EURIBOR – ALL IBORS, BUT DIFFERENT funding are not interbank rates and cannot necessarily be seen as offered rates like in the current definition of Libor. Hence, the “IBO” part of the abbreviation Libor will no longer apply. In general, funding rates from counterparties outside the banking system are likely to be somewhat lower than rates on interbank loans. The reason is that money market funds and corporations that supply funding to banks via CP/CD are not subject to the same regulatory requirements as a bank lending to another bank. Thus, all else equal, the price of funding from outside the banking system will be somewhat cheaper than interbank funding. IBA expects the transition to the new waterfall methodology to be completed by no later than the first quarter of 2019. However, USD Libor already looks very similar to the rates paid for CP-funding by highly rated banks, see Chart 2. Chart 2 shows that in recent years, the 3-month USD Libor has closely followed the rate on 3-month commercial paper issued by the best rated banks (A-1/P-1). During 2011-12, Libor was in fact lower than the corresponding commercial paper rates. This observation must probably be seen in light of the sovereign debt crisis in the euro area. Many of the banks in the US CP market are European, and their perceived credit risk among buyers of commercial paper rose during the crisis. This increased uncertainty was not reflected in Libor to the same extent. Chart 2: Libor and USD CP/CD rates. January 2010 – September 2018. Per cent. Sources: Thomson Reuters and Bloomberg 0 0,5 1 1,5 2 2,5 0 0,5 1 1,5 2 2,5 2010 2011 2012 2013 2014 2015 2016 2017 2018 CP A1/P1 USD LIBOR USD 7 NORGES BANK STAFF MEMO NO. 2 | 2019 NIBOR, LIBOR AND EURIBOR – ALL IBORS, BUT DIFFERENT 4. Euribor Euribor was created with the introduction of the euro in 1999. Currently 20 banks provide their daily submissions to EURIBOR according to the following definition: Euribor is defined as the rate at which euro interbank term deposits are offered by one prime bank to another prime bank within the EMU zone, and is calculated at 11:00 am (CET) for spot value (T+2). Euribor is thus defined as an interbank rate. In contrast to US Libor it is not only an interbank rate in name, but also quoted as one. Chart 3 below shows the same as Chart 2, only for the euro area: The difference between 3-month Euribor and the rate on 3-month commercial paper in euro issued by highly rated European banks. As discussed above, differences in regulatory costs should imply that interbank rates are somewhat higher than comparable rates on banks’ borrowing from non-banks. As can be seen from Chart 3, this is the case for Euribor. The difference is not constant over time. Variation may be due to many factors, like shifts in the demand-supply balance in the CP-market that are not transmitted one-for-one to Euribor. On average since 2011, the spread between 3-month Euribor and the corresponding CP-rate has been 12 basis points. A simple back-of-the-envelope calculation substantiates such a spread. An interbank loan is subject to 20 per cent risk weight in Basel III. Assuming 10 per cent capital requirement and 10 per cent required return on equity, the required spread on top of the borrowing cost is 20 basis points (0.2*0.1*0.1) Since unsecured term lending transactions between banks are rare, the panel banks’ Euribor submissions must to a large extent be based on expert judgement. Panel banks’ submissions reflect what they believe the rates on eligible interbank lending transactions would have been, if they had taken place. This judgement is likely to be informed by rates on traded products in other markets like CP, CD and OIS, adjusted appropriately to reflect interbank term offered rates. 8 NORGES BANK STAFF MEMO NO. 2 | 2019 NIBOR, LIBOR AND EURIBOR – ALL IBORS, BUT DIFFERENT Chart 3: EURIBOR and CP/CD rates. January 2010 – September 2018. Per cent. Sources: Thompson Reuters and Bloomberg Acknowledging the decline in interbank activity, the administrator of Euribor, the European Money Market Institute (EMMI), has launched a program of Euribor reform. An important part of this has been to move from a quote-based methodology to a transaction-based methodology for Euribor. To assess whether a seamless transition from a quotebased to a transaction-based methodology would be feasible, the EMMI ran a so-called pre-live verification program from September 2016 to February 2017. During this period, the EMMI calculated a transactionbased rate based on collected data. In order for a seamless transition to be feasible, the level and volatility of the transaction-based rate would have to be similar to the level and volatility of Euribor. In May 2017, the EMMI presented the outcome of the pre-live testing. It concluded that the level and volatility of the transaction-based rate differed too much from the quote-based Euribor to allow a seamless transition. This conclusion is mirrored by the different behavior of the three month Euribor and corresponding rate on banks’ borrowing via commercial paper in Chart 3 above. As a way forward, the EMMI now plans to introduce a hybrid methodology for Euribor. The EMMI recognizes that the level of liquidity in the unsecured money market is currently not consistently sufficient to base the Euribor calculation solely on transactions. In a consultation paper published in March 2018, the EMMI asked market participants for feedback on the proposed hybrid methodology. In short, the suggested hybrid methodology has many similarities to the waterfall structure for Libor described above. It is suggested to follow a hierarchical approach, where inputs to Euribor submissions are divided into three levels, ranging from real-time eligible transactions to panel banks’ judgement. Eligible transactions include unsecured, fixed rate, cash deposits from banks and a range of non-bank financial institutions, as well as funds obtained from all counterparties via commercial paper and certificates of deposits. -1 -0,5 0 0,5 1 1,5 2 -1 -0,5 0 0,5 1 1,5 2 2010 2011 2012 2013 2014 2015 2016 2017 2018 CP A1/P1 EUR Euribor