LIBOR Transition: What it means for Indian banks

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The Reserve Bank of India (RBI) issued an advisory to banks and other regulated entities on July 8, emphasising the need for them to stop signing new financial contracts that reference the London Interbank Offered Rate (LIBOR) as a benchmark.

The advisory was part of a worldwide transition of financial institutions from old benchmarks to new alternative reference rates.

What is LIBOR?

LIBOR is a benchmark rate against which global banks mark their transactions. It is the interest rate average submitted by leading UK banks. The transition from LIBOR was confirmed on March 5, when the UK Financial Conduct Authority (FCA) issued a statement announcing the cessation dates for all LIBOR settings. The FCA said all LIBOR settings will either cease to be provided by any administrator or no longer be representative after December.

What is the FCA?

The FCA is the conduct regulator for almost 60,000 financial service firms and financial markets in the UK and the prudential supervisor for 49,000 firms, setting specific standards for 19,000 firms.

When will LIBOR cease to exist?

The FCA has set a cut-off date of December 31, 2021, in the case of all pound sterling, euro, Swiss franc and Japanese yen settings (LIBOR transactions), and the 1-week and 2-month US dollar settings. It set June 30, 2023, as the cut-off in the case of remaining US dollar settings.

Why is the LIBOR transition important?

LIBOR is the benchmark rate for all transactions by global banks. According to the RBI, the transition from LIBOR and the adoption of accepted alternative reference rates (ARRs) developed in various jurisdictions is significant and one that needs careful preparation in order to manage potential customer protection, reputational and litigation risks as well as avoid disruptions to the safety and resilience of financial institutions and overall financial stability of the economy.

What has been the RBI’s response on LIBOR transition?

In August 2020, the RBI advised banks and financial institutions to assess their LIBOR exposures that would mature after the cessation of LIBOR and also frame a board-approved plan for steps to be taken to address risks arising from the transition. The regulator has now issued a fresh advisory to banks to prepare for the transition.

What does the latest RBI advisory say?

The RBI said banks and financial institutions need to cease entering into new financial contracts that reference LIBOR as a benchmark and instead use any widely accepted alternative reference rate as soon as practicable and in any case, by December 31, 2021.

The RBI urged banks and financial institutions to incorporate robust fallback clauses in all financial contracts that reference LIBOR and those maturing after the announced cessation date.

Banks have also been advised to cease using the Mumbai Interbank Forward Outright Rate (MIFOR), a benchmark that references LIBOR, as soon as practicable and in any event, by December 31, 2021.

Which will be the new benchmark rate?

There is no final consensus on the new ARR. But it is widely expected that SOFR (secured overnight financing rate ) will be accepted as the new benchmark rate. SOFR is linked to US treasury market transactions and is an identified replacement for USD LIBOR, which is expected to be phased out at the end of 2021.

Have Indian banks begun the shift?

Major Indian banks such as State Bank of India have started using SOFR in place of LIBOR. On January 20, SBI said it executed two interbank short-term money market deals with pricing linked to SOFR.

On January 21, ICICI Bank said it executed the first interbank money market transaction linked to SOFR. The transaction, executed through the bank’s Hong Kong branch, is part of its benchmark transition management plan to assess the preparedness towards a smooth transition to the new ARR, the bank said.

What is the impact of LIBOR transition on banks and companies?

Banks use benchmark rates like LIBOR widely to price international transactions and while issuing other financial instruments. They need to prepare for a transition to cut down future transaction risks by identifying a new benchmark rate at the earliest. Banks will have to work on updating their systems and agreements.

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