Note: Post this article there are changes in maturities for which libor is issued. This article might now be relevant for long tenure transactions (12 Months and Above). Refer link for more details on change in Libor: Change in LIBOR Tenures and Impact on Trade Finance

Banks and Importers consider various factors before going for Buyers Credit transaction for more than 6 months tenure. One such factor is buyers credit with 6 Month Libor Reset option.  The below article elaborates on these factors.

Libor is calculated for 7 different maturities and for 5 different currencies and with longest maturity rate of 12 Month. For simplicity of understanding the below article  considering USD Libor rates only.

For Buyers Credit transaction with tenure more than 6 months but less than 5 years banks use Libor rates with various maturities between 6 Month to 12 Month Libor.

For example: For a buyers credit transaction with maturity of 360 days, buyers credit providing banks can offers quotes at 6 Month Libor with Reset every six months or 12 Month Libor. From bank’s and importer’s point of view, which month Libor maturity is used is important to understand because of risk and cost factors. USD Libor as on October 19, 2012 are as follows:

• 6 Month USD Libor : 0.55940
• 9 Month USD Libor: 0.73250
• 12 Month USD Libor: 0.89650

(For latest Libor rates with different maturities, please click here)

From Banks point of view

Asset Liability Management is the practice of managing risk that arise due to mismatches between the asset and liability (debt and assets) of the bank. Bank manages the risks of asset liability mismatch by matching the assets and liability according to the maturity pattern or the matching of the duration, by hedging and by securitization.

To explain in simple language, when a bank quotes for a buyers credit transaction of 12 Month tenure with 12 month Libor, it means bank had borrowed funds (or has funds for that tenure) from market at that tenure. This removes liquidity risk and interest rate risk.

Interest Rate Risk: Volatility of rate of interest in future

When a bank offers 12 month tenure transaction with 6  month Libor, it means banks had funds for 6 month tenure and the same it is using to fund for 12 month transaction. A situation may arise because of factor not in control of bank where 6 month funds are available in market  at a higher rate than committed rate to importer and extending such transaction further would result into financial loss for funding bank.

For Example.:  X bank funds a buyers credit transaction at 6 Month Libor + 150 bps (bps means Basis Points. A unit that is equal to 1/100th of 1%) with reset clause for a 360 days buyers credit transaction. Incase at the time of reset funds are available at a rate higher than L+150 bps, it would result into loss for funding bank.

This also explains the reason why higher rates are quoted for a transaction which is more than 6 Months. Banks add risk premium while funding the transaction at 6 months Libor reset.

Liquidity Risk: Availability of funds to meet the committed requirement:

During 2008 crisis and 2011 Greece crisis, short-term funds market had dried up.  This resulted in many buyers credit bank out of market for some period. Banks with commitment of long-term transaction (more than 6 months) and with 6 Month Libor reset, had to move back on the commitment.

Both above risk also opens the bank to Reputational Risk also.

From Importers point of view

Importer must consider all the below factors before choosing which options to go for:

• Cost: Among the options provided by various bank, which one is cheaper. In most of the cases 6 Month libor quote would work out to be cheaper. Reason difference between 6 Month libor and 12 Month. As in our earlier example: As on October 19, 2012 difference between 6 Month USD Libor and 12 Month USD Libor is 0.3371 bps. Thus, 6 Month Libor + 150 (with reset) is cheaper by 0.3371 against 12 Month Libor + 150 bps.
• Process: In case of 6 Month Libor reset quote, every 6 months importer will have to pay the interest amount on the due date before further tenure is extended by bank. Whereas in case of 12 Month Libor, interest is payable along with principal  at the end of the tenure or 12 month whichever is earlier.
• As explained in case of Banks point of view, in future in case of crisis if banks are not able to meet its commitment, it would result into higher cost for importers. For example, during Greece crises in 2011, costing in market were as high as 6 Month Libor + 350 bps. In cases where banks moved back on commitment, funds had to be rearranged from other banks at a high cost. In addition there were also cases were importers even after being ready to pay such a higher pricing were not able to get funds. Resulting into using of Term Loan or Working Capital limits as the case may be.

Others

For tenure which are more than 1 year it mainly works to whether it is 6 Months Libor Reset or 12 Month Libor Reset. This is applicable for import of capital goods and infrastructure firms who are looking for arranging funds at one go for the complete tenure.