Given the issues posed by the London Interbank Offered Rate (LIBOR) scandal and the resulting reforms to provide risk-free interest rates, the Reserve Bank of India established precise recommendations for the transition from LIBOR. The RBI has established a system of alternative reference rates (ARRs) that allows banks to choose rates from a basket of currencies rather than the British pound for international financial transactions. The RBI has set a deadline of June 30, 2023, for complete switch-over because some financial institutions are still using LIBOR to conduct business.

The LIBOR transition will impact a wide range of financial institutions across various sectors of the financial industry. These primarily include commercial banks, investment banks, asset managers, insurance companies, hedge funds and private equity firms, pension funds, non-financial corporations, fintech firms and other lending institutions. These institutions will need to transition their existing contracts and develop new products based on alternative reference rates. The transition away from the LIBOR to ARR presents several challenges for financial markets and institutions.

Challenges in transition

Firstly, one of the primary challenges is identifying and adopting suitable alternative reference rates to replace LIBOR. Different jurisdictions and markets have chosen different rates, such as the Secured Overnight Financing Rate (SOFR) in the US, the Sterling Overnight Index Average (SONIA) in the UK, Tokyo Overnight Average Rate (TONA) in Japan and the Euro Short-Term Rate (EU-STR) in the Euro Zone.

As the basket of currency becomes wider, banks and financial institutions need to assess the suitability of these rates for their specific products and contracts to avoid contractual fallback(s); for instance, many financial contracts, such as loans, derivatives, and mortgages, have been tied to LIBOR for decades. Transitioning these contracts to alternative rates requires addressing the fallback provisions, which are contractual clauses that define what happens if LIBOR becomes unavailable or is no longer representative. Updating these provisions can be complex, as they involve legal, operational, and documentation changes.

Secondly, transitioning from LIBOR requires making significant adjustments to internal systems, processes, and models. Banks as well as financial institutions in India need to invest in the necessary technology upgrades and ensure smooth integration without disrupting day-to-day operations.

Thirdly, the introduction of ARR also poses challenges of market liquidity and product availability, this consequently can lead to market inefficiencies and impact pricing and availability of certain financial products. Moreover, transitioning away from LIBOR requires effective communication and engagement with clients and stakeholders. Banks and financial institutions need to educate their clients about the upcoming changes, explain the implications for their contracts and investments, and provide guidance on how to navigate the transition.

Lastly, LIBOR transition involves navigating complex legal and regulatory landscapes as financial institutions will undoubtedly be exposed to legal challenges related to contract interpretation, amendment, and litigation arising from the transition process.

Benefits of transition

The transition from LIBOR has the potential to reduce the cost of financing in several ways as the calculation of alternative reference rates is based on more robust and transparent methodologies which certainly can help reduce the risk premium associated with LIBOR.

Resultantly, lenders and investors may require lower interest rates or spreads, leading to reduced borrowing costs for borrowers. Moreover, customers and clients will be benefited from elimination of “LIBOR premium” which was typically included in their lending rates to compensate for the potential volatility and uncertainty associated with LIBOR.

The introduction of ARR introduces more competition in the market for reference rates. This can lead to more transparent and competitive pricing of financial products, potentially resulting in lower financing costs for borrowers.

Given the lower cost of finances, the alternative reference rates are expected to develop deeper and more liquid markets. This increased liquidity can lead to more efficient pricing and tighter spreads in the market, benefiting borrowers.

Given India’s growing economic heft, the transition to globally aligned standards such as the Financial Stability Board’s recommendations and the International Organisation of Securities Commissions (IOSCO) are in our interest. The alignment of Indian banks and financial institution to international standards promotes consistency and comparability across markets, reducing uncertainty and facilitating cross-border transactions. The increased harmonisation can help reduce the cost of financing for borrowers accessing international markets.

The way forward

The transition from LIBOR to alternative reference rates involves several steps. A lot has been achieved in capacity building of Indian banks but financial institutions such as pension funds, insurance companies, hedge funds, non-banking institutions still face challenges to assess the impact of the LIBOR transition on their existing contracts, products, and financial instruments. There is a need to supplement the capacity of these institutions to evaluate and select appropriate alternative reference rates that are recommended by the RBI.

Lastly, communication is the essence of success and banks and financial institutions should devise a strategy to inform and educate customers about the transition from LIBOR to alternative reference rates. This involves providing clear and timely communication about the changes, impacts on existing contracts, and any actions required from customers.

The writer is Professor, IIFT New Delhi. Views expressed are personal