Finance | What next for NIBOR?
The expected discontinuance of LIBOR after 2021 has led to a worldwide search for adequate replacement reference rates for financial transactions. In Norway, the working group on alternative reference rates has suggested NOWA as the preferred, alternative reference rate to NIBOR. NOWA is a wholly transaction based overnight rate, based on the average of interest rates for unsecured loans between banks. In light of this, we explore the differences between NIBOR and NOWA and look at a few challenges the alternatives face.
What is a reference rate and what happened to LIBOR?
Reference rates are used in a wide variety of transactions as a basis for calculating interest payable, yield and other economic metrics and are meant to be a measure of the interest rate banks pay for interbank loans. LIBOR (London Interbank Offered Rate) is calculated based on submissions from a group of banks of what rates they could borrow for certain terms (one month, three month etc.). The Norwegian Benchmark Rate (NIBOR) is calculated the same way. As a result of lower volume in the Norwegian market, the borrowing often goes through FX-swaps, and NIBOR thus stems from a USD interest rate.
Following the financial crisis in 2008, when LIBOR for a time did not reflect actual funding rates for banks, and the LIBORgate scandal, where it was found that LIBOR had been fraudulently manipulated, alternative reference rates (ARRs) to the world’s most famous reference rate since 1969 have been sought. As a consequence, working groups have been established in many countries, and LIBOR is predicted to be discontinued after 2021 as the UK’s Financial Conduct Authority (FCA) from then on no longer will require banks to provide the rate quotes LIBOR is calculated on.
What alternatives are there?
The leading contender ARR in the US is the Secured Overnight Financing Rate (SOFR), whilst the Bank of England has proposed the Reformed Sterling Overnight Index Average (SONIA) and the Euro Short-Term Rate (ESTER) has been devised by the European Central Bank. All of these ARRs are overnight rates (based on payment the same day, and repayment the following banking day), whilst IBORs are published for multiple terms.
The overnight rates have the benefit of reflecting actual rates in a market with a high transaction volume, and thus being more “real” market rates, than LIBOR which is based on estimates by a group of banks for their future funding rates.
NOWA instead of NIBOR?
The working group to find alternatives to NIBOR in Norway was established by Norges Bank in April 2018, and the group handed over their first report in October 2018. Different ARRs were outlined, and the working group recommended NOWA (Norwegian overnight weighted average), or a “reformed” NOWA (explained below) as a replacement reference rate. The NOWA regulation is set out by Finans Norge, with Norges Bank as calculation agent. There are currently eleven banks on the panel, reporting to Norges Bank. In line with most of the other ARRs referred to above, NOWA is a wholly transaction-based overnight rate, based on the average of interest rates for agreements on unsecured loans between banks.
NOWA is also more sensitive than NIBOR to changes of the folio rate set by Norges Bank, which was one of the working group’s criteria in search for an ARR. NOWA is however affected by lack of liquidity in the market on certain days such as the end of year or quarter, which can lead to a spike in the rates quoted on such days based on a lower than usual transaction volume. SOFR, the US ARR, has seen significant spikes recently around certain dates, such as at the end of 2018.
Given that most transaction pricing has not been based on overnight rates, but rates for longer terms such as three month LIBOR or NIBOR, where the reference rate is quoted on the day the transaction is entered into and is reset every three months, the ARRs such as NOWA and SOFR give a borrower less predictability since the three month rate would not be calculated until the end of the three month period, based on the average of the overnight rates during that term, exposing the borrower to the volatility in the overnight market in that period. The SONIA-referencing market will provide a borrower more certainty in respect thereof by lagging the interest period by 5 banking days. As a consequence, the final interest payment will be certain five days before due date.
Another challenge with NOWA is that the transaction volume in the Norwegian market is limited in general, which raises concerns as to whether NOWA is based on a sufficiently robust and reliable market. Despite these challenges, NOWA is the only available overnight rate in Norway.
The working group is currently exploring ways to address these concerns, e.g. by changing NOWA from a lending rate to a funding rate, and by eliminating the highest and lowest estimate days on which NOWA has to be estimated (a “reformed” NOWA). The working group intends to publish the final report at the end of June, 2019.