About The LIBOR

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:

1. About LIBOR
2. Controversies Surrounding LIBOR
3. Alternative to LIBOR: Secured Overnight Financing Rate (SOFR)
4. 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