LONDON
INTERBANK OFFERED RATE (LIBOR) - ECONOMY
News: Explained | Why are financial regulators
transitioning from LIBOR?
What's in the news?
● On
May 12, the RBI stated that some banks and financial institutions were yet to
facilitate an absolute transition away from the London Interbank Offered Rate
(LIBOR) benchmark.
Key takeaways:
● They
had not inserted fallback clauses into all their financial contracts that
reference U.S.$ LIBOR or the corresponding domestic Mumbai Interbank Forward
Outright Rate (MIFOR).
● Both LIBOR and MIFOR
would cease to be a representative benchmark from June 30 this year.
The regulator urged the entities to incorporate the clauses to avert any
“last-minute rush to insert fallbacks''.
● The
RBI had stated in its November 2020 bulletin that, in India, exposures to LIBOR
are from loan contracts linked to it, Foreign Currency Non-Resident Accounts
(FCNRA-B) deposits with floating rates of interest and derivatives.
LIBOR:
● LIBOR
is a global benchmark interest rate
that combines individual rates at which banks opine they may borrow from each
other (for a particular period of time) at the London interbank market.
● It
is used as a benchmark to settle trades
in futures, options, swaps and other derivative financial instruments in
over-the-counter markets (participants engaging directly without using an
exchange) and on exchanges globally.
● Further,
consumer lending products including mortgages, credit cards and student loans,
among others, to use it as a benchmark rate.
How was LIBOR calculated?
● Before
December 31, 2021, LIBOR was calculated for five currencies (U.S. dollar, Euro, Pound, Swiss Franc and Japanese
Yen) for seven tenors (overnight,
one-week, one-month, two months, three months, six months and 12 months). Thus,
totaling to 35 individual rates on each business day.
● Only
U.S.-dollar LIBOR, excluding one-week and two-month tenor, were allowed to be
published after the U.K. The Financial Conduct Authority (FCA) announced its
phased rollback in March 2021.
Issues:
● The
central flaw in the mechanism was that it relied heavily on banks to be honest with their reporting disregarding
their commercial interests.
Alternatives:
● Secured Overnight
Financing Rate (SOFR) - USA. Accordingly, in India,
new transactions were to be undertaken using the SOFR and the Modified Mumbai Interbank Forward Outright
Rate (MMIFOR), replacing MIFOR.