the story So Far: On 12 May, the RBI said that some banks and financial institutions have not yet facilitated a full transition from the London Interbank Offered Rate (LIBOR) benchmark. They did not include fallback clauses in all their financial contracts that referred to US$ LIBOR or the corresponding domestic Mumbai Interbank Forward Outright Rate (MIFOR). Both LIBOR and MIFOR will cease to be representative benchmarks from June 30 this year. The regulator urged the entities to include the clause to prevent any “last-minute rush to insert fallbacks”.
What is LIBOR?
LIBOR is a global benchmark interest rate that combines the different rates at which banks agree they can borrow from each other (for a specified period) in the London interbank market. It is used as a benchmark for settling trades in futures, options, swaps and other derivative financial instruments in over-the-counter markets (participants connect directly without using an exchange) and on exchanges globally. . In addition, other consumer loan products including mortgages, credit cards and student loans also use it as a benchmark rate.
Before 11 a.m. (London time) every business day, banks on the LIBOR panel make presentations to Thomson Reuters, a news and financial data company. The panel includes commercial bankers such as JPMorgan Chase (London branch), Lloyds Bank, Bank of America (London branch), Royal Bank of Canada and UBS AG. After submission, the contribution rates are ranked. The extreme quartiles, top and bottom, are excluded and the middle quartiles are averaged to obtain LIBOR. The idea is to get as close to the median as possible.
Prior to December 31, 2021, LIBOR is calculated for five currencies (US Dollar, Euro, Pound, Swiss Franc and Japanese Yen) for seven tenors (overnight, one week, one month, two months, three months, six months and 12) was done for month). Thus, a total of 35 different rates on each business day. Only the US-dollar LIBOR was allowed to be published except for a period of one week and two months after the UK Financial Conduct Authority (FCA) announced a phased rollback in March 2021.
What was the controversy about it?
The central flaw in the system was that it relied heavily on banks to be honest with their reporting, disregarding their commercial interests.
It should be noted that the rates were made public. Therefore, it will not be particularly useful to tell potential and current customers about the various pitfalls in receiving money. The phenomenon was particularly prominent during the 2008 financial crisis when productions were artificially reduced (in the midst of the crisis). In 2012, Barclays admitted misconduct and agreed to pay $160 million in penalties to the US Department of Justice. The Wall Street Journal also found in a May 2008 study that many panelists were paying “significantly lower borrowing costs” than other measures of the market. Another observed phenomenon was the tendency of the institutions to change the submission (higher or lower) according to the derivatives position of the trading units in order to gain higher profits. Derivative refers to financial contracts whose value is related to a specific indicator, commodity or financial instrument.
Prior to February 2014, LIBOR was administered by the British Bankers’ Association (BBA). However, in April 2013 the maintenance of the benchmark was brought under the purview of the FCA.
Do we have a Choice?
Yes, in 2017, the US Federal Reserve announced the Secured Overnight Financing Rate (SOFR) as the preferred option. Accordingly, in India, new transactions were to be carried out using SOFR and Modified Mumbai Interbank Forward Outright Rate (MMIFOR) instead of MIFOR.
As stated by the International Finance Corporation (IFC), it is based on observable repo rates, or overnight borrowing costs, collateralized by US Treasury securities. Thus, making it a prevailing transaction-based rate and moving away from the need for an expert judgment in the form of LIBOR. This would potentially make it less prone to market manipulation.
MMIFOR will use the adjusted SOFR (combined into outstandings for various periods and obtained from Bloomberg Index Services), among other components.
The SOFR is published every market trading day at 8:00 a.m. ET.
How are we responding to regime change?
Indian Banks’ Association (IBA) said this Hindu that there were a number of products linked to LIBOR that had to be redesigned with an alternate reference rate (ARR) as the base. Two working groups formed by the association helped develop it with guidance from the RBI. In addition, another set of challenges was related to technology and legal aspects (such as handling legacy contracts, modification of contracts with counter parties/interbank as well as borrowers). IBA notes that the challenges were addressed “very effectively”.
For the necessary systemic and technical changes, the association informed, “Banks will have to identify products that are linked to LIBOR and aggregate risk. Information to customers about the transition, insertion of fallback clauses in contracts, impact assessment on their P&L, change in technology platform etc. are required to facilitate the transition,” further added, “We understand that banks are ready For perspective, the fullback clause refers to an agreement to revise views when the reference rate is no longer published – important for transparency and consistency.
The RBI in its November 2020 bulletin had said that, in India, exposures to LIBOR are through loan contracts linked to it, Foreign Currency Non-Resident Accounts (FCNRA-B) with floating rates of interest and derivatives.
Overall, the idea is to create a framework to manage “potential customer protection, reputational and litigation risks” and avoid disruption to the safety and resilience of financial institutions and the overall financial stability of the economy.
The story has been updated to include quotes from industry observers.