End of LIBOR: Indian banks, companies need to be guided by policymakers

| Updated on October 18, 2019 Published on October 17, 2019

Despite the announcement of LIBOR’s phase-out, many new long-dated derivative contracts, maturing after 2021, continue to be benchmarked to the rate

As companies that borrow in overseas markets get ready for a new era post-2020, one in which the London Interbank Offered Rate no longer exists, policymakers need to gear up too, to smoothen the process. This transition is not likely to be easy, as trillions of dollars of loans and derivatives will have to be re-priced. While some companies may benefit, many could incur losses and legal as well as account-related problems could emerge. LIBOR, which is the rate at which banks borrow wholesale unsecured loans from each other, has been the world’s most preferred benchmark so far. But it is not difficult to see why the decision to discontinue the rate was taken. The manner of arriving at the LIBOR has come under severe criticism since 2012, when it was found that a few banks were manipulating it. The rate is based on the estimates of the cost of funds of a panel of banks and therefore reflects the credit profile of a narrow set of banks. The rate is also no more relevant since the transactions in the interbank market have dwindled since the global financial crisis. With over $300 trillion of loans and derivatives referenced to it, the transition could cause a severe upheaval in global markets.

Of concern is the fact that many firms are either unaware or unwilling to make the adjustments needed to transition to other alternative reference rates, yet. According to the Bank of England, in loan markets, LIBOR-linked lending continues to dominate. Despite the announcement of the phase-out, many new long-dated derivative contracts, maturing after 2021, continue to be benchmarked to the LIBOR. But the sooner companies begin adjusting to the new regime, the better. With Indian firms increasingly turning to overseas market for their financing needs, challenges lie ahead. A large part of the external commercial borrowings, that account for 38 per cent of our external debt, is likely to be referenced to the LIBOR, with the ultimate interest rate charged dependent on the credit risk profile of the company. Indian banks as well as corporates need to find a viable alternative benchmark.

It is good that the Indian Banks’ Association has set up a working group to study the impact of the transition. The Reserve Bank of India should also study the impact of this change and issue guidelines to banks. Many countries have begun offering alternatives to the LIBOR. Since mid-2018, the UK has begun publishing the revamped Sterling Overnight Index Average (Sonia) and the US is publishing Secured Overnight Financing Rate (Sofr). The Euro short-term rate (estr) and Japan’s Tokyo overnight average rate (Tonar) are other alternatives for borrowers. The RBI could study these options and help suggest the most viable rate to overseas borrowers. Besides this, the central bank will also have to guide banks and companies on the manner in which the transition needs to be accounted for in the books.

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Published on October 17, 2019
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