FCA warns banks to play fair in switch from Libor to Sonia

The financial watchdog has warned banks it will be watching like a hawk to ensure they play fair as they shift businesses and borrowers from the discredited Libor interest rate.

A senior Financial Conduct Authority director told This is Money that if it sees problems with banks it will ‘challenge hard’ and ‘intervene’, to reassure businesses who fear they may use it as a ruse to hike rates.

The FCA and Bank of England want banks to move away from Libor, which was embroiled in a fixing scandal during the financial crisis, and onto a new benchmark rate called Sonia.

But banks that have begun writing to firms and borrowers about the shift – affecting rates paid on loans by British businesses and an estimated 200,000 UK mortgage holders – have told them that they will face a ‘cost premium’ on top of the new risk-free rate.

The FCA admitted to This is Money that it would permit banks to charge a small premium to make up the difference between Libor and Sonia, but it would make sure that they ‘calculate that scrupulously fairly’.

‘We will be keeping a very close eye on it,’ said Edwin Schooling Latter, Director of Markets and Wholesale Policy at the FCA.

He said that the message to banks from the FCA was that they must play fair and we will be watching you.

Mr Schooling Latter said: ‘One thing that must not happen is the discontinuation of Libor leaves customers on a replacement rate expected to be higher than Libor.

He added: ‘Any place we see evidence of that happening we will challenge hard and intervene where we need to.’

Businesses being written to about the shift from Libor to Sonia are being told they will face cost premiums and fear banks will try to profit off the back of the switch.

One businessman, who asked not to be named, said that he feared banks were trying to ‘bake in’ a little extra on the rate from the start.

Both the watchdog and Bank of England told This is Money they will crackdown if they see this happening.

However, confidence is low following a series of recent financial scandals on the FCA’s watch, including star manager Neil Woodford’s wrecked fund and investors losing £230million in the London Capital & Finance collapse. 

Yesterday, the Bank of England took steps to ‘turbo-charge’ the move away from Libor, adding extra costs for banks who still use it after October. It wants a full shift away from Libor by the end of 2021.

Libor is a global benchmark interest rate that affects an estimated $30 trillion dollars worth of financial contracts.

It is based on responses from banks, who are asked at what rate they would be willing to lend to each other, and a scandal emerged after the financial crisis when it was discovered that traders had been colluding to fix the rate to profit from their bets on it.

Some of the world’s biggest banks, including Barclays, Deutsche Bank and UBS were caught up in the scandal and one British UBS trader Tom Hayes was sentenced to 11 years in jail for his role in rigging Libor.

Since the Libor scandal, the financial authorities have moved to clean up the system but want to shift to a new risk-free rate of return benchmark that financial contracts and loans can be based on.

This is partially because the rate was discredited by the fixing saga, but also due to flaws in Libor, which reflects banks’ own assessment of the risk involved in lending to rivals.

When the credit crunch hit and the financial system seized up, central banks took emergency measures and slashed their own interest rates, such as the Bank of England’s Bank Rate.

But Libor remained stubbornly high, as it reflected banks’ fears that they would not get their money back if they lent to each other.

This meant that businesses and borrowers with loans linked to Libor failed to benefit from lower payments and cheaper borrowing costs due to Bank Rate being slashed, as the Bank of England wanted.

The Bank of England explained that Sonia – as the sterling overnight index average is called – is a more scientific and clinical rate than Libor and does not have the element of credit risk in it.

That means that in the event of another financial crisis, it should fall in line with central bank interest rates. With rates around the world still near record low levels, this is considered crucial to fight any problems.