The Reserve Bank of India (RBI) has recently advised all banks and regulated entities to transition from the London Interbank Offered Rate (LIBOR) to Alternative Reference Rates (ARR). With the banking industry’s stability and integrity in mind, this transition is expected to reduce reliance on LIBOR which is often susceptible to manipulation. This move is significant due to LIBOR’s widespread usage as a global benchmark interest rate.
Understanding LIBOR
Known officially as the London Interbank Offered Rate, LIBOR represents the average interest that banks predict they can borrow from one another in the interbank market of London over specific time frames. This rate plays a crucial role as it is used as a reference point for settling trade in various financial instruments such as futures, options, swaps, and other derivatives. Banks submit their estimated borrowing rates every business day to Thomson Reuters, a news and finance company, which calculates the LIBOR rate by averaging the remaining rates after removing the extreme ones. This calculation aims to reflect the median borrowing rate precisely.
LIBOR’s Significance
Many lenders, borrowers, investors, and financial institutions depend on LIBOR to determine interest rates and pricing for various transactions. Besides its use in financial markets, LIBOR also acts as a benchmark for consumer lending products like mortgages, credit cards, and student loans. This benchmark hence assists in setting the interest rates that individuals and businesses pay on these loans.
RBI’s Switch from LIBOR
The RBI is transitioning away from LIBOR because of concerns about its reliability and integrity. The main flaw with LIBOR is its heavy dependence on the banks providing truthful and accurate reporting of their borrowing rates, without considering their commercial interests. This paves the way for potential manipulation and misconduct. In the 2008 financial crisis, some banks subtly lowered their LIBOR submissions to present a more favorable image amidst the crisis. This inconsistency spurs concerns about the integrity and fairness of the benchmark.
The Alternative to LIBOR
In 2017, the U.S. Federal Reserve introduced the Secured Overnight Financing Rate (SOFR) as an alternative to LIBOR. Recommended for new transactions in India, SOFR is used with the Modified Mumbai Interbank Forward Outright Rate (MMIFOR), replacing Mumbai Interbank Forward Outright Rate (MIFOR). As opposed to LIBOR, SOFR is derived from actual transactions, thereby making it less susceptible to market manipulation. The introduction of SOFR and MMIFOR aims to offer a more dependable transaction-based benchmark for financial contracts, thereby reducing the risks linked with LIBOR.
Challenges in Shifting from LIBOR
The transition from LIBOR to ARR comes with its share of challenges. These include the redesigning of many products linked to LIBOR with an ARR base and dealing with existing contracts while communicating necessary modifications to counterparties, interbank entities, and borrowers. Consequentially, there are significant systemic and technical changes that banks need to adopt, including identifying LIBOR-tied products, determining overall exposure, and adjusting their technology platforms accordingly.
A Way Forward
To facilitate this robust transition, banks should continue to devise products linked to LIBOR with the newly introduced ARR as the foundation. Simultaneously, they must focus on managing existing contracts and making suitable modifications with counterparties, interbank entities, and borrowers. Moreover, banks need to evaluate the impact of this shift on their profit and loss statements and make necessary adjustments to their technology platforms to ensure a smooth transition.
