Explained | What is LIBOR and why the new RBI instructions?

RBI

On May 12, the Reserve Bank of India (RBI) asked banks and other regulated entities to take steps to ensure a complete transition away from the London Interbank Offered Rate (LIBOR) from July 01, 2023.

The RBI has told banks to ensure that no new transaction undertaken by them or their customers relies on or is priced using the USD LIBOR or the Mumbai Interbank Forward Outright Rate (MIFOR).

What is LIBOR and why is it in the news? Here’s an explainer to help understand the issue.

What is LIBOR?

LIBOR is an average of the estimated interest rates submitted by leading UK banks. LIBOR is a benchmark rate against which global lenders mark their transactions.

When was the decision to withdraw the LIBOR first announced?

On March 05, 2021, The Financial Conduct Authority (FCA) of the United Kingdom (UK) announced that all LIBOR settings (interest rates)  will either cease to be provided or no longer be representative.

The FCA said the LIBOR will cease to exist after December 31, 2021, in the case of all Pound Sterling, Euro, Swiss Franc, and Japanese Yen settings, and the 1-week and 2-month US Dollar settings. The remaining US Dollar settings would cease to exist after June 30, 2023.

What is FCA?

The FCA is the conduct regulator for nearly 60,000 financial services firms and financial markets in the UK, and the prudential supervisor for 49,000 firms. It defines specific prudential standards for 19,000 firms.

A conduct regulator’s goal is to ensure honest and fair markets for individuals, businesses, and the economy as a whole. The Authority does this by protecting consumers, promoting competition, etc. For instance, a conduct regulator will look for unfair treatment of customers by way of hidden penalties for products, mis-spelling, and dishonest marketing.

Prudential supervision goes beyond the quantitative analysis of a firm’s financials and considers systems and controls, governance, risk management, etc.

Around 19,000 firms have to meet specific prudential standards of the FCA. These standards cover the financial resources firms must have, and ensure that client assets are protected if the firm fails. While the remaining 30,000 firms don’t have to meet specific standards, they must still make sure they have sufficient resources and fulfil the conditions all firms must meet.

What was wrong with LIBOR?

In 2012, it came to light that many global banks had colluded to manipulate the LIBOR. The LIBOR also had a role to play in escalating the 2008 financial crisis. As a result, many central banks and regulatory authorities decided to move away from the benchmark.

What's RBI's stand on this?

In India, the RBI advised banks to stop entering into LIBOR-linked contracts latest by December 31, 2021. Major banks like SBI and ICICI Bank soon announced a transition to new benchmark rates.  The latest move is likely to have some transitory impact on banks.

What are the latest RBI instructions?

On May 12, RBI asked banks and RBI-regulated entities to take steps to ensure a complete transition away from the LIBOR from July 01, 2023. Banks and financial institutions (FI) were advised to ensure that no new transaction undertaken by them or their customers relies on or is priced using the USD LIBOR or the MIFOR.

What will replace LIBOR?

The RBI has offered options like the SOFR (Secured Overnight Financing Rate), which is linked to US treasury market transactions, and the Modified Mumbai Interbank Forward Outright Rate (MMIFOR). SOFR is considered a more accurate and more secure pricing benchmark.

What exactly is SOFR?

SOFR is a broad measure of the cost of borrowing cash overnight, collateralised by (US) treasury securities in the repo market. It is based on the actual market activity and is not dependent on a few firms to set the rates.

What will be the impact of LIBOR transition on banks and companies?

Banks use benchmark rates like LIBOR to price international transactions while issuing financial instruments. Banks will have to work on updating their systems and agreements.

Since LIBOR has been used for a long time, the transition will be a complex exercise for banks. The same is true for large companies that are looking at international borrowings or bond issues.