From Tasneem Chherawala
The LIBOR has been the key interest rate for financial products for three and a half decades. But according to the dictates of the British Financial Conduct Authority (FCA), LIBOR is due to retire on December 31st. Why is LIBOR dying? How would the world be without LIBOR? What will the transition requirements and costs be?
A number of developments have reduced regulators’ confidence in LIBOR. The global financial crisis in 2007 caused LIBOR to deviate sharply from other short-term risk-free rates such as government bond yields and overnight index swap (OIS) rates due to heightened perception of credit and liquidity risk. The significantly higher LIBOR volatility compared to other refinancing rates also gave cause for concern during the crisis.
After the crisis, a number of LIBOR-related scandals came to the fore, involving global banks deliberately manipulating their prices to either project financial soundness or explicitly benefit from better valuations of their own exposures. As the volume of interbank term loans has recently contracted, the basis of LIBOR on actual market transactions has also been questioned. With his impending death, international financial markets are preparing to phase him out and switch to Alternative Reference Interest Rates (ARRs). This will have a significant impact on nearly $ 400 trillion in outstanding financial contracts by 2021 whose pricing, valuation, accounting and risk management are currently linked to LIBOR.
The RBI also recently advised banks and FIs on how to ensure a smooth LIBOR transition. That’s easier said than done. The first topic will be the selection of the appropriate benchmarks to replace LIBOR. Working groups in different jurisdictions have created and recommended multiple ARRs in different currencies – SOFR in the US, SONIA in the UK, TONAR in Japan and ESTR in Europe. Some of these resonate with financial trades, but nowhere near LIBOR. Financial Benchmarks India Ltd. (FBIL), the administrator of financial market rates in India, has started publishing the adjusted and modified MIFOR rates derived from SOFR. These will be the appropriate reference rates for relevant interest rate swaps after the USD LIBOR is discontinued. However, for cash and derivative securities directly linked to LIBOR, the choice of FER must be carefully considered.
Another problem is identifying the current exposures that are directly or indirectly affected by the LIBOR replacement. RBI data shows that India’s total external debt was $ 563.5 billion in December 2020 and more than $ 2.5 trillion in foreign exchange and interest rate derivatives outstanding in March 2020, related exposures such as external commercial bonds, private and public bilateral and multilateral bonds, FCNR (B) deposits borrowed from banks, currency interest rate swaps, etc. Renegotiation of the contract.
This not only requires approval of the corresponding fallback rates, but also adjustments to these rates, as the term LIBOR has integrated credit, term and liquidity premiums, while RRs are purely risk-free overnight rates.
Banks also need to quickly develop products that reference RRs, consistent with regulatory expectations and market protocols, in order to use them for new business. Only a handful of the major Indian banks have taken an initiative in dollar transactions related to SOFR – namely ICICI Bank and SBI for interbank money market operations; SBI for setting up an ECB for IOCL; and Axis Bank for a derivatives trade.
Another focus is on adjustments to internal models, processes and systems for assessment and risk management. Yield curves have to be re-modeled; Spreads over ARRs need to be re-estimated; The historical price volatilities used in value-at-risk models must be adjusted. The accounting and tax effects of these changes must be assessed.
The LIBOR transition will not be child’s play. The on-site progress of Indian companies that have significant LIBOR exposure is not clear. The challenges of ensuring regime change are enormous and can lead to market disruptions if not properly planned.
Assistant Professor, National Bank Management Institute
Get live stock quotes from BSE, NSE, US market and the latest NAV, mutual fund portfolio, read the latest IPO news, best performing IPOs, calculate your taxes with the income tax calculator, know the top winners , Top losers and best equity funds in the market. Like us on Facebook and follow us on Twitter.
Financial Express is now on Telegram. Click here to join our channel and stay up to date with the latest biz news and updates.