TRANSITION FROM LIBOR

TRANSITION FROM LIBOR

CONTEXT :

• Recently, the Reserve Bank of India (RBI) told banks and other regulated entities to ensure a complete transition away from the London Interbank Offered Rate (LIBOR) from July 1.

MORE ABOUT THE NEWS:

• The RBI has established a system of alternative reference rates (ARRs) that allows banks to choose rates from a basket of currencies rather than the British pound for international financial transactions.
• The RBI has set a deadline of June 30, 2023, for complete switch­over because some financial institutions are still using LIBOR to conduct business.
• The LIBOR transition will impact a wide range of financial institutions across various sectors of the financial industry.
• These primarily include commercial banks, investment banks, asset managers, insurance companies, hedge funds and private equity firms, pension funds, non­-financial corporations, fintech firms and other lending institutions.
• These institutions will need to transition their existing contracts and develop new products based on alternative reference rates.

• The transition away from the LIBOR to ARR presents several challenges for financial markets and institutions.

WHAT IS LIBOR ?

• 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, which stands for London Interbank Offered Rate, serves as a globally accepted key benchmark interest rate that indicates borrowing costs between banks.
• The rate is calculated and will continue to be published each day by the Intercontinental Exchange (ICE), but due to recent scandals and questions around its validity as a benchmark rate, it is being phased out.

• LIBOR is the average interest rate at which major global banks borrow from one another.
• It is based on five currencies including the U.S. dollar, the euro, the British pound, the Japanese yen, and the Swiss franc.
• It serves seven different maturities overnight/spot next, one week, and one, two, three, six, and 12 months.

CHALLENGES IN TRANSITION FROM LIBOR:

• SUITABLE ALTERNATIVE: One of the primary challenges is identifying and adopting suitable alternative reference rates to replace LIBOR.
• Different jurisdictions and markets have chosen different rates, such as the Secured Overnight Financing Rate (SOFR) in the US, the Sterling Overnight Index Average (SONIA) in the UK, Tokyo Overnight Average Rate (TONA) in Japan and the Euro Short­Term Rate (EU­STR) in the Euro Zone.
• Transitioning these contracts to alternative rates requires addressing the fallback provisions, which are contractual clauses that define what happens if LIBOR becomes unavailable or is no longer representative.
• Updating these provisions can be complex, as they involve legal, operational, and documentation changes.
• INTERNAL ADJUSTMENTS: Transitioning from LIBOR requires making significant adjustments to internal systems, processes, and models.
• Banks as well as financial institutions in India need to invest in the necessary technology upgrades and ensure smooth integration without disrupting day ­to ­day operations.
• CHALLENGES WITH ARR: The introduction of ARR also poses challenges of market liquidity and product availability, this consequently can lead to market inefficiencies and impact pricing and availability of certain financial products.
• LIBOR transition involves navigating complex legal and regulatory landscapes as financial institutions will undoubtedly be exposed to legal challenges related to contract interpretation, amendment, and litigation arising from the transition process.

BENEFITS FROM TRANSITION:

• The transition from LIBOR has the potential to reduce the cost of financing in several ways.
• Lenders and investors may require lower interest rates or spreads, leading to reduced borrowing costs for borrowers.
• Customers and clients will be benefited from elimination of “LIBOR premium” which was typically included in their lending rates to compensate for the potential volatility and uncertainty associated with LIBOR.
• The introduction of ARR introduces more competition in the market for reference rates.
• This can lead to more transparent and competitive pricing of financial products, potentially resulting in lower financing costs for borrowers.
• Given the lower cost of finances, the alternative reference rates are expected to develop deeper and more liquid markets.
• This increased liquidity can lead to more effcient pricing and tighter spreads in the market, benefiting borrowers.

HARMONISATION WITH INTERNATIONAL STANDARDS:

• The alignment of Indian banks and financial institution to international standards promotes consistency and comparability across markets, reducing uncertainty and facilitating cross-­border transactions.
• The increased harmonisation can help reduce the cost of financing for borrowers accessing international markets.

WAY FORWARD:

• Although a lot has been achieved in capacity building of Indian banks but there is a need to supplement the capacity of pension funds, insurance companies, hedge funds, non-­banking institutions to evaluate and select appropriate alternative reference rates that are recommended by the RBI.
• Banks and financial institutions should devise a strategy to inform and educate customers about the transition from LIBOR to alternative reference rates.

SYLLABUS: MAINS, GS-3, INDIAN ECONOMY

SOURCE: BUSINESSLINE