The financial regulators are shifting from LIBOR, a global benchmark interest rate. What is the contentious issue involving the global benchmark interest rate? How is this related to the global financial crisis of 2008? Read here to understand more.
According to the RBI, several banks and financial institutions have not yet enabled a complete move away from the benchmark London Interbank Offered Rate (LIBOR).
All of their financial contracts that refer to U.S. dollar LIBOR or the equivalent local Mumbai Interbank Forward Outright Rate (MIFOR) do not have fallback clauses.
From June 30 of 2023, LIBOR and MIFOR will both no longer serve as representative benchmarks. To avoid any “last-minute rush to insert fallbacks,” the regulator asked the firms to include the clauses.
What is LIBOR?
As the market for interest rate-based products started to develop in the 1980s, a standard measure of interest rates across financial institutions became required.
- BBA interest-settlement rates were established in 1984 by the British Bankers’ Association (BBA), which represented the banking and financial services sector.
- BBA LIBOR, which became the preferred standard interest rate for transactions in the interest rate and currency-based financial dealings between financial institutions at the local and international levels, was developed in 1986 as a result of further streamlining.
The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans.
LIBOR combines the various rates at which banks believe they may borrow money from one another (for a specific amount of time) on the London interbank market.
- It serves as a benchmark to settle trading in futures, options, swaps, and other derivative financial instruments on exchanges throughout the world as well as in over-the-counter markets, where players deal directly with one another without utilizing an exchange.
- Additionally, it serves as a benchmark rate for consumer lending products such as mortgages, credit cards, and student lhers.
It is based on five currencies- the U.S. dollar, the euro, the British pound, the Japanese yen, and the Swiss franc, and serves seven different maturities-overnight/spot next, one week, and one, two, three, six, and 12 months.
- A total of 35 distinct LIBOR rates are calculated and reported each business day as a result of the combination of five currencies and seven maturities.
- The three-month U.S. dollar rate, often known as the current LIBOR rate, is the rate that is most frequently reported.
According to the Federal Reserve and regulators in the UK, LIBOR will be phased out by June 30, 2023, and will be replaced by the Secured Overnight Financing Rate (SOFR).
Calculation of LIBOR
The rate is calculated using the Waterfall Methodology, a standardized, transaction-based, data-driven, layered method.
The rate is calculated and published each day by the Intercontinental Exchange (ICE) Benchmark Administration (IBA).
- Each currency and tenor pair has a designated panel of international banks assembled by the IBA.
- For instance, the panel for U.S. dollar LIBOR is made up of 16 large institutions, including Bank of America, Barclays, Citibank, Deutsche Bank, JPMorgan Chase, and UBS.
- The ICE LIBOR panel is only open to institutions that play a substantial role in the London market, and the selection procedure is conducted yearly.
What is LIBOR used for?
LIBOR is used globally in a wide assortment of financial products.
- The forward rate agreements (FRA), interest rate swaps, interest rate futures, options, and swaptions, which provide purchasers the right but not the obligation to acquire a security or interest rate product, are common interbank products.
- Commercial items include variable-rate mortgages, floating-rate certificates of deposits and notes, and syndicated loans, which are loans provided by several lenders
- Hybrid products include a variety of accrual notes, callable notes, and perpetual notes, as well as collateralized debt obligations (CDO), collateralized mortgage obligations (CMO), and others.
- Student loans and other consumer loan-related goods, such as individual mortgages
Issues with LIBOR
Despite being a long-standing worldwide benchmark for interest rates, LIBOR has not been without controversy, including a significant rate-rigging incident.
- It is suspected that top banks conspired to manipulate LIBOR rates. They provided intentionally low LIBOR rates to maintain the rates at the traders’ desired levels.
- The purpose of the alleged wrongdoing was to increase the earnings of traders who had positions in financial securities dependent on LIBOR.
Because of doubts about LIBOR’s dependability and integrity, the RBI is also abandoning it.
- The LIBOR mechanism’s main weakness is that it heavily relies on banks to disclose their borrowing rates honestly and accurately, disregarding their economic interests. Misconduct and manipulation are made possible by this.
- Some banks purposefully reduced their LIBOR filings during the 2008 financial crisis to provide a more favorable picture. Compared to other market measurements, panelists were reporting much-reduced borrowing costs.
New system: SOFR
The new approach is intended to substitute actual transaction rates for the speculative interest rate thinking that predominated under LIBOR.
In 2023, LIBOR will be replaced by the secured overnight financing rate (SOFR).
- The SOFR is a benchmark interest rate used for derivative contracts and loans with dollar-denominated principal.
- In contrast to LIBOR, which relied on estimates of borrowing rates, SOFR is based on actual observed transactions in the U.S. Treasury market.
While other nations are considering utilizing their version of a benchmark rate for when LIBOR is phased out, SOFR is most likely to be utilized in the U.S. and the U.K.
The Modified Mumbai Interbank Forward Outright Rate (MMIFOR), which took the place of the Mumbai Interbank Forward Outright Rate (MIFOR), was advised for use in new transactions in India.
- The modified SOFR rates, which are compounded retroactively for various periods, are included in MMIFOR. These rates are derived, among other places, from the Bloomberg Index Services.
To lower the risks associated with LIBOR, SOFR, and MMIFOR were introduced to provide a more trustworthy and transaction-based benchmark for financial contracts.
The switch from LIBOR to an Alternate Reference Rate is difficult in terms of technological and regulatory considerations.
- These difficulties included dealing with already-written contracts and modifying them as needed with counterparties, interbank organizations, and borrowers.
- Essential systemic and technological reforms must be made by banks. These adjustments entail figuring out the total exposure and identifying goods linked to LIBOR.
- Customers must also be informed about the transition, backup provisions must be added to contracts to cover situations where the reference rate is unavailable, the impact on profit and loss statements must be evaluated, and required changes must be made to technological systems.
The interest rates on short-term loans made between banks were represented by the London Interbank Offered Rate, a benchmark used around the world.
But in 2012, when certain bankers were found to be manipulating the index for their gain, the index came under scrutiny.
Most countries have since phased out LIBOR and many have proposed their regional variants.
- For instance, Europe has the European Interbank Offered Rate (EURIBOR), Japan has the Tokyo Interbank Offered Rate (TIBOR), China has Shanghai Interbank Offered Rate (SHIBOR), and India has the Mumbai Interbank Offered Rate (MIBOR).
-Article written by Swathi Satish