LIBOR BENCHMARK

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RBI recently stated that some financial institutions were yet to facilitate an absolute transition away from the LIBOR benchmark.

What is LIBOR?

• The London Interbank Offered Rate (LIBOR) is a global benchmark interest rate that combines individual rates at which banks opine they may borrow from each other at the London interbank market.
• It is used as a benchmark to settle trades in futures, options, swaps and other derivative financial instruments in over-the-counter markets and on exchanges globally.
• The consumer lending products including mortgages, credit cards and student loans, among others also use LIBOR as a benchmark rate.
• Before December 31, 2021, LIBOR was calculated for five currencies (U.S. dollar, Euro, Pound, Swiss Franc and Japanese Yen) for seven tenors i.e., overnight, one-week, one-month, two months, three months, six months and 12 months.
• Only U.S.-dollar LIBOR, excluding one-week and two-month tenor, were allowed to be published after U.K. Financial Conduct Authority (FCA) announced its phased rollback in March 2021.
• The central flaw in the mechanism of LIBOR was that it relied heavily on banks to be honest with their reporting disregarding their commercial interests.
• Since the rates were made public, it would not be particularly useful to impress upon potential and current customers the various disadvantages in obtaining funds.
• During the 2008 financial crisis the submissions were artificially lowered (amid the crisis).
• Another observed phenomenon was the tendency to alter the submission as per the entities’ trading units’ derivative positions to acquire more profits.
• Derivates refer to financial contracts whose value is related to a specific indicator, commodity or financial instrument.
• The maintenance of the benchmark was brought under the purview of the U.K. Financial Conduct Authority (FCA) from British Bankers’ Association (BBA) in 2014.

What are the alternates to LIBOR?

• The U.S. Federal Reserve announced the Secured Overnight Financing Rate (SOFR) as a preferred alternative in 2017.
• Accordingly, in India, new transactions were to be undertaken using the SOFR and the Modified Mumbai Interbank Forward Outright Rate (MMIFOR).
• This would make it potentially less prone to market manipulation.

How India is responding to the Regime Change?

• RBI had stated in 2020 that exposure to LIBOR is from loan contracts linked to it and from Foreign Currency Non-Resident Accounts (FCNR-B) deposits with floating rates of interest and derivatives.
• The same year RBI had asked banks to assess their LIBOR exposure and prepare for the adaptation of alternatives references rates.
• However, in May 2023, RBI stated that some banks and financial institutions were yet to facilitate an absolute transition away from the London interbank offered Rate benchmark.

SOURCE: THE HINDU, THE ECONOMIC TIMES, PIB