The Bank of England's decision to extend the London interbank offered rate transition and its use to underpin the U.S. Federal Reserve's coronavirus lending puts the 2021 deadline to end its use under pressure.

The BoE has said it will delay to April 2021 from October 2020 moves aimed at encouraging banks to use its favored replacement interest rates for Libor.

It said it will delay plans to increase so-called haircuts, which are applied to banks using Libor-linked collateral to borrow, to incentivize them to switch to the regulators' favored alternative risk-free rates.

The BoE has also extended the deadline for banks to keep issuing loans tied to Libor to April 2021 from October 2020. British financial regulators said they recognized that it will not be feasible to complete the transition away from Libor across all new sterling Libor-linked loans by the original target date of the end of the 2020 third quarter.

Penalty system postponed

The loan market is already behind other parts of the Libor-using market in switching to new risk-free rates.

"Not only has the Bank postponed the deadline to stop issuing new Libor-linked loans by six months, it has delayed by the same period its 'penalty system' of applying haircuts to collateral, designed to motivate firms away from holding stocks of Libor-linked assets and continue the evolution towards risk-free rates," said Rupert Lewis, head of banking litigation at law firm Herbert Smith Freehills in London.

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Lewis said: "While pushing these interim milestones back by six months may provide some breathing space in the cash market for now, it will undoubtedly ramp up the pressure on firms to achieve Libor transition in this market by the fixed deadline of end 2021.

"Most importantly, this delay will have the effect of increasing the pool of loans referencing Libor when the benchmark ceases. In turn, this will increase the litigation risks for legacy contracts, particularly where fallbacks in new loans require renegotiation when Libor ends."

Libor has long been used to underpin trillions of dollars of financial transactions including cash loans, credit card rates, interest rate derivatives and mortgages. It is set by a panel of banks each day that use information on interbank lending interest rates along with their judgement to decide what the benchmark interest rate should be for the months ahead.

'Risk free'

Since various U.S. and European banks were found to have attempted to manipulate the Libor rate, and faced huge fines for doing so, regulators on both sides of the Atlantic have urged market participants to switch to so-called risk-free rates, set in arrears and based on actual overnight borrowing rates. They have set a deadline of the end of 2021 for markets to stop using Libor.

The BoE currently requires a 25% cut on the value of Libor-linked collateral banks have to put up when borrowing from it, known as hair-cutting. This was due to be increased by 10 percentage points from October, but that will now be delayed until April 2021.

In the U.S., policymakers have turned to Libor as the benchmark for the $600 billion Main Street Lending Program, which will see the Federal Reserve purchase loans that banks give to small and medium-sized businesses. The Fed will purchase up to 95% of each loan with banks keeping the remainder on their books to encourage responsible lending.

The Fed originally intended to use the scheme to push its preferred risk-free replacement rate for Libor, called Sofr — the secured overnight financing rate.

However, after resistance from the U.S. banking industry, which feared that businesses were unfamiliar with the newer rate, it chose to stick with Libor. But by doing so it has made markets' transition away from the benchmark index harder.

"The key problem is that program loans have a four-year maturity and will therefore continue beyond the cessation of Libor at end-2021. The overall effect will be to create a large volume of new Libor-linked products in the market, potentially exposing all parties participating in the loans to the risks inherent in renegotiating the switch from Libor to Sofr (or an alternative rate) later down the line when Libor comes to an end," said Lewis.

Favorable conditions

Darrell Duffie of Stanford University, who has said the transition from Libor is a bigger task than the creation of the eurozone, agreed.

"The Fed's decision to allow Libor was reasonable, given the crisis priority of getting the Main Street Lending Program going quickly. But yes, indexing these loans to Sofr would have made it easier to transition away from Libor by the end of 2021," Duffie said.

Despite the potential for serious delays to the ultimate timetable for ending the use of Libor, the effects of the pandemic may prove favorable for transition, said analysts at ING.

"It is not inconceivable that one year from now we find that Libor has calmed to a more 'normal' level, and that risk-free rates in arrears are flat to risk-free rates in advance, as official rates remain low and the forwards benign. If we get that, we could find, remarkably, that conversion rates are stable and close to historical medians," it wrote in a note to investors.