London Interbank Offered Rate (LIBOR)

Subject : Economy

Section: Monetary Policy

Concept :

The Reserve Bank of India (RBI) has asked the banks and financial institutions to facilitate a complete transition away from the London Interbank Offered Rate (LIBOR) by the 1st of July 2023.

London Interbank Offered Rate (LIBOR)

LIBOR is a globally accepted benchmark interest rate at which major global banks may borrow from one another in the international (London) interbank market for short-term loans.
LIBOR is used as a benchmark to settle trades in futures, options, swaps and other derivative financial instruments in over-the-counter markets and on exchanges.
Furthermore, LIBOR is also used as a benchmark rate for consumer lending products such as credit cards, mortgages, student loans, corporate debt, etc.
Every business day before 11 a.m. (London time), banks on the LIBOR panel make their submissions to Thomson Reuters, which is a news and financial data company.
This LIBOR panel comprises commercial bankers such as J.P. Morgan Chase (London branch), Lloyds Bank, Bank of America (London branch), Royal Bank of Canada, UBS AG, etc.
The contributed rates are then ranked based on the LIBOR submission.
During the ranking process, extreme quartiles are excluded and the middle quartiles are averaged to derive the LIBOR.
This is in line with the idea of being as close to the median as possible.

Controversy surrounding LIBOR

Recently, there have been efforts to phase out LIBOR because of its role in worsening the Financial Crisis of 2008 and also due to the scandals involving LIBOR manipulation among rate-setting banks.
Critics have pointed out that the mechanism adopted by LIBOR relied heavily on banks to be honest with their reporting disregarding their commercial interests.
Investigations have revealed a long-lasting scheme among various banks to manipulate rates in order to acquire more profit.

Other alternatives to LIBOR

The U.S. Federal Reserve in 2017, announced the Secured Overnight Financing Rate (SOFR) as an alternative to LIBOR.
Post the introduction of SOFR, new transactions in India were to be undertaken using the SOFR and the Modified Mumbai Interbank Forward Outright Rate (MMIFOR), replacing LIBOR and its corresponding domestic Mumbai Interbank Forward Outright Rate (MIFOR).
SOFR is a rate produced by the U.S. Federal Reserve Bank based on transaction data (observable repo rates which are collateralised by U.S. Treasury securities) and is not based on estimates by experts as in LIBOR.
Thus, SOFR is considered to be more accurate and less prone to market manipulation.
RBI had asked banks in India to assess their LIBOR exposures and initiate their preparations to adopt alternative reference rates.
Contracts that were signed after December 31, 2021, were told not to use the LIBOR as a reference rate and the contracts that were entered before the date were to have fallback clauses for revised considerations when the LIBOR is completely phased out.