Banks face squeeze as Libor replacements fall short -BIS

LONDON, March 5 (Reuters) - Replacements for the tarnished Libor interest rate benchmark could squeeze bank funding, with the costs borne by customers, the Bank for International Settlements said on Tuesday.

The London Interbank Offered Rate (Libor) is based on polls of selected banks, and lenders were fined billions of dollars for trying to manipulate their submissions during the financial crisis a decade ago.

Financial contracts ranging from home loans to derivatives and worth about $400 trillion referenced Libor in major currencies in mid-2018.

The Federal Reserve, the Bank of England and other major central banks now publish overnight rates for use instead of Libor. These “risk-free” rates are seen as harder to manipulate as they are based on actual market transactions rather than quotes.

Regulators are piling pressure on banks to use the new rates by the end of 2021.

But the BIS cautioned in its quarterly review that finding a single “Swiss army knife” replacement for Libor to meet all users’ needs will not be possible.

Even devising forward or “term” rates based on overnight rates to better mimic the breadth of Libor will not help banks cover marginal funding costs or when they borrow in order to lend.

“A sudden spike in their short-term borrowing rates can pull the rug from under their feet during episodes of financial stringency, squeeze their margins, and subject the system as a whole to broader stress,” said Hyun Song Shin, head of research at BIS.

“This may call for a pragmatic and tailored approach. For instance, risk-free rates could be complemented with some forms of credit-sensitive benchmark.”

If these risks cannot be adequately hedged, it is likely they would be passed on to clients in one form or another. A number of different benchmark formats could therefore coexist to fulfil a variety of purposes and market needs, it said.

Japan and the euro zone were already taking a “two benchmark” approach by introducing risk-free rates and reforming their region’s Libor counterpart to make it harder to manipulate.

“The jury is still out on whether any resulting market segmentation would lead to material costs and inefficiencies, or whether this ‘new normal’ might actually be optimal.”

Britain’s Financial Conduct Authority has said banks may not be willing to continue submitting quotes to sterling Libor after the end of 2021, meaning a twin approach there could be harder to achieve.

Reporting by Huw Jones; editing by John Stonestreet