Context:
Recently, the RBI stated that some banks and financial institutions were yet to facilitate an absolute transition away from the London Interbank Offered Rate (LIBOR) benchmark.
Relevance:
GS III: Indian Economy
Dimensions of the Article:
- About LIBOR
- Controversies Surrounding LIBOR
- Alternative to LIBOR: Secured Overnight Financing Rate (SOFR)
- Response to the Regime Change from LIBOR
About LIBOR
- LIBOR, or the London Interbank Offered Rate, is a widely used benchmark interest rate.
- LIBOR is a global benchmark interest rate that combines individual rates at which banks opine they may borrow from each other (for a particular period of time) at the London interbank market.
Applications and Significance:
- Benchmark for financial instruments:
- Used as a reference rate for settling trades in various financial instruments, including futures, options, swaps, and other derivatives.
- Applied in over-the-counter markets and on exchanges globally.
Impact on consumer lending:
- Serves as a benchmark rate for consumer lending products, such as mortgages, credit cards, student loans, and more.
- Determines the interest rates offered to consumers by financial institutions.
Indicator of financial system health:
- Provides insights into the stability and liquidity of the financial system.
- Helps assess the potential direction of central bank policy rates.
Controversies Surrounding LIBOR:
Integrity and Reporting Accuracy:
- Banks were relied upon to provide honest reporting of their borrowing rates.
- This system neglected the potential conflict of interest that banks might have had in manipulating the rates for their own benefit.
Concealment of Disadvantages:
- As LIBOR rates were publicly disclosed, banks had little incentive to disclose any difficulties they faced in obtaining funds.
- During the 2008 financial crisis, some banks artificially lowered their rate submissions, concealing the true extent of their financial distress.
Barclays’ Misconduct and Penalties:
- In 2012, Barclays admitted to misconduct related to LIBOR manipulation.
- The bank agreed to pay $160 million in penalties to the U.S. Department of Justice as a result.
- Discrepancies in Borrowing Costs:
- The Wall Street Journal reported in May 2008 that some panelists paid significantly lower borrowing costs than other market measures indicated.
- This suggested a potential discrepancy between reported LIBOR rates and the actual costs of borrowing.
Profit-Motivated Rate Alteration:
- There were instances of banks adjusting their rate submissions based on the derivative positions of their trading units to enhance their profitability.
- This manipulation could result in inaccurate and misleading LIBOR rates.
Alternative to LIBOR: Secured Overnight Financing Rate (SOFR)
- In 2017, the U.S. Federal Reserve introduced the Secured Overnight Financing Rate (SOFR) as a preferred alternative to LIBOR.
- India also adopted the use of SOFR, along with the Modified Mumbai Interbank Forward Outright Rate (MMIFOR), to replace the existing MIFOR for new transactions.
Features of SOFR:
- Based on observable repo rates: SOFR is derived from repo transactions, which involve borrowing cash overnight collateralized by U.S. Treasury securities.
- Transaction-based rate: It is determined by actual market transactions, making it a more reliable and transparent benchmark.
- Reduces reliance on expert judgment: Unlike LIBOR, SOFR eliminates the need for expert judgment in rate-setting, reducing the potential for market manipulation.
Advantages of SOFR:
- Reduced manipulation risk: By using actual transaction data, SOFR is designed to be less susceptible to manipulation compared to LIBOR.
- Increased transparency: SOFR is based on observable market rates, promoting transparency and enhancing market confidence.
- Reflective of collateralized borrowing costs: As a secured rate, SOFR captures the cost of borrowing cash collateralized by U.S. Treasury securities accurately.
Response to the Regime Change from LIBOR:
Assessment of LIBOR Exposures:
- The Reserve Bank of India (RBI) instructed banks to evaluate their exposures to LIBOR in loan contracts, Foreign Currency Non-Resident Accounts (FCNR-B) deposits, and derivatives.
- This assessment aimed to understand the extent of reliance on LIBOR and facilitate the transition to alternative reference rates.
Adoption of Alternative Reference Rates:
- The RBI directed banks to prepare for the adoption of alternative reference rates, such as SOFR and MMIFOR, to replace LIBOR.
- Contracts entered into after December 31, 2021, were required to use the new reference rates instead of LIBOR.
Inclusion of Fallback Clauses:
- Contracts entered into before the specified date were advised to include fallback clauses.
- These clauses would outline revised considerations and terms in case LIBOR is no longer published, ensuring transparency and consistency in contractual agreements.
Regulatory Guidance and Support:
- The RBI provided guidance and support to banks throughout the transition period.
- This assistance aimed to facilitate a smooth and orderly shift away from LIBOR to alternative reference rates.
- The response to the regime change involved a proactive approach by the RBI, emphasizing the assessment of exposures, adoption of alternative rates, and the inclusion of fallback clauses to ensure a seamless transition away from LIBOR.
-Source: The Hindu
