Banks to Make Complete Transition From LIBOR

What’s in today’s article?

• Why in news?
• London Interbank Offered Rate (LIBOR)
• What is London Interbank Offered Rate (LIBOR)?
• How Is Libor Calculated?
• Why LIBOR is being Phased Out?
• News Summary: Banks to make complete transition from LIBOR

 

Why in news?

• 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.
• The central bank advised banks and financial institutions not to do new LIBOR-linked or the Mumbai Interbank Forward Outright Rate (MIFOR)-linked financial deals.

 

London Interbank Offered Rate (LIBOR)

What is London Interbank Offered Rate (LIBOR)?

• LIBOR is a widely used benchmark interest rate that is used to determine the cost of borrowing for many financial instruments, including loans, mortgages, and derivatives. 
• It is the average interest rate at which major banks in London are willing to borrow unsecured funds from each other in the interbank market. 
• Banks and private companies were using LIBOR as the benchmark rate for raising funds abroad.
• Libor is calculated daily for: 
  • five currencies: UK Pound Sterling, the Swiss Franc, the Euro, Japanese Yen and the U.S. Dollar; and
  • seven maturities (overnight, one week, one month, two months, three months, six months, and twelve months).
• Published by
  • LIBOR is published by the Intercontinental Exchange (ICE) and is based on submissions from a panel of major banks.
    • The ICE is an American company that owns and operates financial and commodity marketplaces and exchanges. 
    • It was founded in May 2000 in Atlanta, Georgia. 
    • ICE operations include futures exchanges, cash exchanges, central clearing houses, and market services for off-exchange trading.

 

How Is Libor Calculated?

• Each day, 18 international banks submit their ideas of the rates they think they would pay if they had to borrow money from another bank on the interbank lending market in London.
• To help guard against extreme highs or lows that might skew the calculation, the ICE strips out the four highest submissions and the four lowest submissions before calculating an average.
• It should be noted that Libor is not set on what banks actually pay to borrow funds from each other. 
• Instead, it is based on their submissions related to what they think they would pay. 
• As a result, it is possible for banks to submit lower rates and manipulate Libor fairly easily.

 

Why LIBOR is being Phased Out?

• Susceptibility to manipulation
  • LIBOR is being phased out due to concerns over its reliability and susceptibility to manipulation. 
  • The benchmark rate was at the center of a major scandal in 2012 when it was revealed that several banks had colluded to manipulate LIBOR rates for their own benefit. 
  • Since then, there have been numerous investigations and legal cases related to LIBOR manipulation.
• Libor and the 2008 Financial Crisis
  • LIBOR played a significant role in the 2008 financial crisis, as it was used as a benchmark rate for many financial instruments, including mortgages, loans, and derivatives
• Accuracy of LIBOR and its ability to reflect true market conditions
  • The interbank lending market that LIBOR was designed to reflect has become less active in recent years, and there are fewer transactions on which to base LIBOR calculations. 
  • This has led to concerns about the accuracy of the benchmark rate and its ability to reflect true market conditions.
• Regulators around the world developing new benchmark rates
  • The Secured Overnight Financing Rate (SOFR) is the main replacement for Libor in the United States. 
    • This benchmark is based on the rates U.S. financial institutions pay each other for overnight loans. 
  • In the UK, the Sterling Overnight Index Average (SONIA) is replacing LIBOR. This is based on actual transactions in the overnight unsecured lending market.

 

News Summary: Banks to make complete transition from LIBOR

• RBI has asked banks and financial institutions to adopt by July 1 a widely accepted Alternative Reference Rate, such as the Secured Overnight Financing Rate (SOFR).
• Banking entities in India have been told to complete the transition from the scandal-hit LIBOR and Mumbai Interbank Forward Outright Rate (MIFOR).
  • MIFOR is the rate that Indian banks use as a benchmark for setting prices on forward-rate agreements and derivatives. 
  • MIFOR is a mix of the London Interbank Offered Rate and a forward premium derived from Indian forex markets.

 

---

Q1) What is Mumbai Interbank Forward Outright Rate (MIFOR)?

Mumbai Interbank Forward Outright Rate (MIFOR) is the rate that Indian banks use as a benchmark for setting prices on forward-rate agreements and derivatives. MIFOR is a mix of the London Interbank Offered Rate and a forward premium derived from Indian forex markets.

 

Q2) What is Secured Overnight Financing Rate (SOFR)?

SOFR is a benchmark interest rate that measures the cost of borrowing cash overnight, collateralized by US Treasury securities.

 

---

Source: RBI tells banks to complete transition from LIBOR by July | Forbes Advisor | The Hindu | Economic Times