LIBOR
1. Context
Recently, RBI stated that some banks and financial institutions were yet to facilitate an absolute transition away from the London Interbank Offered Rate (LIBOR) benchmark.
They had not inserted fallback clauses into all their financial contracts that reference U.S. dollars LIBOR or the corresponding domestic Mumbai Interbank Forward Outright Rate (MIFOR).
Both LIBOR and MIFOR would case to be a representative benchmark from June 30 this year.
2. About 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) 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, use it as a benchmark rate.
- Every business day before 11 a.m. (London time), banks on the LIBOR panel make their submissions to news and financial data company, Thomson Reuters.
- The panel consists of commercial bankers such as J.P. Morgan Chase (London Branch), Royal Bank of Canada and UBS AG, among others.
- Following the submission, the contributed rates are ranked. On the top and bottom, extreme quartiles are excluded and the middle quartiles are averaged to derive the LIBOR. The idea is to be as close to the median as possible.
3. Controversy
- The central flaw in the mechanism was that it relied heavily on banks, to be honest with their reporting disregarding their commercial interests.
- The rates were made public. Therefore, it would not be particularly useful to impress upon potential and current customers the various disadvantages of obtaining funds.
- The phenomenon was particularly on display during the 2008 financial crisis when submissions were artificially lowered (amid the crisis).
- Another observed phenomenon was the tendency to alter (higher or lower) the submission as per the entity's trading units' derivative positions to acquire more profits.
4. Alternative place
- In 2017 the U.S. Federal Reserve announced the Secured Overnight Financing Rate (SOFR) as a preferred alternative.
- Accordingly, in India, new transactions were to be undertaken using the SOFR and the Modified Mumbai Interbank Forward Outright Rate (MMIFOR), replacing MIFOR.
- As stated by the International Finance Corporation (IFC), it is based on observable repo rates, or the cost of borrowing cash overnight, which is collateralised by U.S. Treasury securities.
- Thus, making it a prevailing transaction-based rate and drifting away from the requirement of an expert judgement as in LIBOR. This would make it potentially less prone to market manipulation.
5. Response to the Regime Change
- The RBI has stated in its November 2020 bulletin that, in India, exposures to LIBOR are from loan contracts linked to it and Foreign Currency NonResident Accounts (FCNRB) deposits with floating rates of interest and derivatives.
- The banking regulator had asked banks to assess their LIBOR exposures and prepare for the adoption of alternative reference rates.
- Contracts entered after (or before, if possible) December 31, 2021, were not to use the LIBOR as a reference rate.
- More importantly, contracts entered before the date were to have fallback clauses, that is an agreement for revised considerations when the reference rate is no more published important for transparency and consistency.
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For Prelims: LIBOR, FCNRB, MMIFOR, RBI, International Finance Corporation, MIFOR, SOFR, Global Financial Crisis
For Mains:
1. What is London Interbank Offered Rate? Explain the Controversial story surrounding the global benchmark interest rate during the 2008 Global Financial Crisis. (250 Words)
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Previous Year Questions
1. Consider the following statements about LIBOR and choose the wrong statement (SEBI GRADE A)
A. LIBOR stands for The London Interbank Offered Rate
B.The five currencies for which LIBOR is computed are Swiss franc, euro, pound sterling, Japanese yen and US dollar.
C. LIBOR serves maturities that range from overnight to 10 years
D. The LIBOR Scandal came to light in 2012, which is a major episode of financial collusion in which one of the world’s most influential benchmark interest rates was manipulated by various banks.
E. LIBOR will be phased out and eventually be replaced by Secured Overnight Financing Rate (SOFR) by June 2023
Answer: C
2. Consider the following: (UPSC 2021)
1. Foreign currency convertible bonds
2. Foreign institutional investment with certain conditions
3. Global depository receipts
4. Non-resident external deposits
Which of the above can be included in Foreign Direct Investments?
A. 1, 2 and 3 B. 3 only C. 2 and 4 D. 1 and 4
Answer: A
3. With reference to 'IFC Masala Bonds' sometimes seen in the news, which of the statements given below is/are correct? (UPSC 2016)
1. The International Finance Corporation, which offers these bonds, is an arm of the World Bank.
2. They are the rupee-denominated bonds and are a source of debt financing for the public and private sector.
Select the correct answer using the code given below.
A. 1 only B. 2 only C. Both 1 and 2 D. Neither 1 nor 2
Answer: C
4. With reference to the International Monetary and Financial Committee (IMFC) consider the following statements: (UPSC 2016)
1. IMFC discusses matters of concern affecting the global economy and advises the International Monetary Fund (IMF) on the direction of its work.
2. The World Bank participates as an observer in IMFC's meetings.
Which of the statements given above is/are correct?
A. 1 only B. 2 only C. Both 1 and 2 D. Neither 1 nor 2
Answer: C
5. If another global financial crisis happens in the near future, which of the following actions/policies are most likely to give some immunity to India? (UPSC 2020) (CMAT 2021)
1. Not depending on short-term foreign borrowings.
2. Opening up to more foreign banks.
3. Maintaining full capital account convertibility.
Select the correct answer using the code given below:
A. 1 only B. 1 and 2 only C. 3 only D. 1, 2 and 3
Answer: A
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Source: The Hindu
