Context:
The Reserve Bank of India (RBI) has recommended banks and other Regulated Entities to abandon the London Interbank Offered Rate (LIBOR) in favor of Alternative Reference Rates (ARR).
In order to ensure the stability and integrity of the financial system, the move away from LIBOR aims to reduce reliance on a benchmark that is vulnerable to manipulation.
What is LIBOR?
Description:
- LIBOR is a commonly used global interest rate benchmark. It is the average interest rate at which banks think they can borrow from one another in the London interbank market for a given time period.
- LIBOR is significant because it is used to settle contracts in a variety of financial products such as futures, options, swaps, and other derivatives.
Calculation:
- Every business day, a group of banks sends their projected borrowing rates to Thomson Reuters, a news and financial data organization, to calculate LIBOR.
- The extreme rates are removed, and the remaining rates are averaged to arrive at the LIBOR rate, which is intended to represent the median borrowing rate.
- LIBOR formerly was calculated for five main currencies and seven different time periods, yielding 35 rates released each day.
- Only U.S. dollar LIBOR rates were permitted to be published after December 31, 2021, as the UK Financial Conduct Authority phased out the majority of these rates.
Importance:
- LIBOR is used by many lenders, borrowers, investors, and financial institutions to set interest rates and pricing for these transactions.
- LIBOR is utilized not only in financial markets, but also as a benchmark rate for consumer lending products such as mortgages, credit cards, and student loans.
- It contributes to the determination of the interest rates that individuals and corporations pay on these loans.
Why is the RBI abandoning LIBOR?
Reliability and Integrity Issues:
- LIBOR is being phased out by the RBI due to concerns about its dependability and integrity.
- The basic weakness in the LIBOR method is its dependence on banks to give honest and accurate reporting of their borrowing rates, without regard for their business interests. This opens the door to manipulation and infractions.
- At the 2008 financial crisis, certain banks artificially reduced their LIBOR filings in order to create a more favorable picture. When compared to other market metrics, panelists reported much lower borrowing costs.
Concerns about Integrity and Fairness:
- Banks have a tendency to change their LIBOR submissions based on the derivative holdings of their trading units in order to achieve bigger profits.
- This raises questions about the benchmark's integrity and impartiality.
What serves as LIBOR's substitute?
- The Secured Overnight Financing Rate (SOFR) was introduced by the Federal Reserve of the United States in 2017 as an alternative to LIBOR.
- In India, new transactions should use SOFR in conjunction with the Modified Mumbai Interbank Forward Outright Rate (MMIFOR), which has replaced the Mumbai Interbank Forward Outright Rate (MIFOR).
- SOFR is determined by observable repo rates. These rates reflect the cost of borrowing money overnight and are backed by US Treasury securities.
- SOFR, as opposed to LIBOR, is drawn from actual transactions, making it less subject to market manipulation.
- MMIFOR, on the other hand, includes altered SOFR rates that are compounded retroactively for various time periods. These rates are collected, among other sources, from Bloomberg Index Services.
- SOFR and MMIFOR are intended to provide a more trustworthy and transaction-based benchmark for financial contracts, thereby lowering the risks associated with LIBOR.
What are the Difficulties in Transitioning from LIBOR?
- Many products that were connected to LIBOR have to be developed with an Alternate Reference Rate (ARR) as the foundation.
- Two working groups formed by the association and guided by the RBI assisted in its development.
- There are technological and legal difficulties when switching from LIBOR to an ARR. These difficulties included negotiating with existing contracts and modifying them with counterparties, interbank companies, and borrowers.
- Banks must make critical systemic and technical adjustments. These modifications entail identifying items linked to LIBOR and calculating overall exposure. Banks must also notify clients about the transition, provide fallback clauses in contracts to cover scenarios in which the reference rate is no longer available, assess the impact on their profit and loss statements, and make appropriate changes to their technology infrastructure.
The Next Steps:
- The new ARR must serve as the foundation for the banks' ongoing efforts to revamp LIBOR-linked products. The association's two working groups, with supervision from the RBI, play a critical role in building the essential framework for this transition.
- To address technological and legal hurdles, banks must focus on managing existing contracts and making necessary changes with counterparties, interbank entities, and borrowers.
- To ensure a smooth transition, banks must examine the impact on their profit and loss statements and make any necessary improvements to their IT platforms.
