LIBOR: What, Why and Why Not?

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In this article, I have tried to touch upon the concepts like what is LIBOR, why is it no longer in use, who has succeeded it. Before delving deep into this, let's see the current scenario worldwide and in India.

For more than 40 years, the London Interbank Offered Rate - commonly known as LIBOR - was a key benchmark for setting the interest rates charged on adjustable-rate loans, mortgages and corporate debt.

Over the last decade, Libor has been burdened by scandals and crises. Effective January 2022, Libor is now no longer used to issue new loans in the U.S. It is replaced by the Secured Overnight Financing Rate (SOFR), which many experts consider a more accurate and more secure pricing benchmark.

Coming to India, In terms of RBI Press Release dated May 12, 2023 on 'Cessation of LIBOR: Complete Transition' the Financial Benchmarks India Pvt. Ltd. (FBIL)  ceased to publish MIFOR after June 30, 2023. In the light of the foregoing and in terms of the FBIL's Benchmarks Cessation Policy it has been decided, with the approval of the RBI and the FBIL Board of Directors, to discontinue the computation and publication of FBIL MIFOR immediately after June 30, 2023 for all the six tenors, viz. Overnight, 1-month, 2-month, 3-month, 6-month and 12-month.

What is LIBOR?

• 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.
• The London Interbank Offered Rate (LIBOR) is the benchmark interest rate at which large international banks expect to lend to one another.
• It's important to note that Libor isn't set on what banks actually pay to borrow funds from each other. Instead, it's based on their submissions related to what they think they would pay. As a result, it's possible for banks to submit lower rates and manipulate Libor fairly easily.
• To help guard against extreme highs or lows that might skew the calculation, the Intercontinental Exchange (ICE) Benchmark Administration strips out the four highest submissions and the four lowest submissions before calculating an average.
• Libor provided loan issuers with a benchmark for setting interest rates on different financial products. It was set each day by collecting estimates from up to 18 global banks on the interest rates they would charge for different loan maturities, given their outlook on local economic conditions. Libor was calculated in five currencies: UK Pound Sterling, the Swiss Franc, the Euro, Japanese Yen and the U.S. Dollar.
• The London Interbank Offered Rate was used to price adjustable-rate mortgages, asset-backed securities, municipal bonds, credit default swaps, private student loans and other types of debt.

In short,

• The average is then calculated using these numbers.ICE Benchmark Administration (IBA) is in charge of the administration.
• The Financial Conduct Authority (FCA) of the United Kingdom regulates it.
• Intercontinental Exchange polls major worldwide banks every day to see how much they would charge for short-term loans.
• It is based on five currencies: The US dollar, Euro, British Pound, Japanese Yen, and Swiss Franc, and it has seven possible maturity periods.
• Each business day, 35 separate LIBOR rates are calculated and presented due to the combination of 5 currencies and 7 maturities.
• The three-month US dollar rate, often known as the current LIBOR rate, is the most commonly cited rate.

LIBOR SCANDALS AND THE 2008 FINANCIAL CRISIS

• Libor is being phased out in large part because of the role it played in worsening the 2008 financial crisis, as well as scandals involving Libor manipulation among the rate-setting banks.

• The use of credit default swaps (CDS) to insure risky mortgages and other financial products was a major factor in the 2008 financial crisis. CDS rates were set using Libor, and these derivative investments were used to hedge against defaults on subprime mortgages.
• One of the biggest players in the CDS market was American International Group (AIG). AIG issued vast quantities of CDS on subprime mortgages and other financial products. When the real estate market crashed in 2007, AIG was forced into bankruptcy. This led to a loss of confidence in the CDS market, as investors realized that the underlying assets were not properly insured.
• The collapse of the CDS market made it difficult for banks to lend to each other. This was because Libor, the rate used to set interest rates on many loans, rose sharply. Libor rose because banks were afraid of lending money to each other, and they were therefore demanding higher interest rates to compensate for the risk.
• The rise in Libor made it more expensive for businesses and consumers to borrow money. This led to a decline in economic activity, which in turn worsened the financial crisis.
• With rates on trillions of dollars of financial products soaring day after day, and fears about stunted bank lending reducing the flow of money through the economy, markets crashed. Libor was only one of the many factors that created the financial industry disasters of 2008, but its key role in transmitting the crisis to all parts of the global economy has driven many nations to seek safer alternatives.

Here are some additional details to help you understand the whole scenario in a better way

• CDS are a type of financial derivative that allows one party to transfer the risk of default on a debt obligation to another party.
• The 2008 financial crisis was a global economic crisis that began in the United States and spread to other countries. The crisis was caused by a number of factors, including the collapse of the housing market, the subprime mortgage crisis, and the failure of several large financial institutions.
• A subprime mortgage is a loan made to borrowers with poor credit histories or other risk factors. These borrowers are typically charged higher interest rates than borrowers with good credit, and they may also be required to make larger down payments.
• Subprime mortgages are often used by borrowers who are unable to qualify for a traditional mortgage. They may also be used by borrowers who are looking for a loan with a lower monthly payment than a traditional mortgage. They are the loans given at a very high rate, larger down payments and more restrictive terms.
• However, subprime mortgages can be risky for both borrowers and lenders. Borrowers with poor credit histories are more likely to default on their loans, which can lead to foreclosure. Lenders who make subprime loans are more likely to lose money if borrowers default.
• The subprime mortgage crisis of 2008 was caused in part by the widespread availability of subprime mortgages. Many borrowers who could not afford to repay their loans were able to get them anyway, thanks to lax lending standards. When the housing market crashed, many of these borrowers defaulted on their loans, which led to a wave of foreclosures and a financial crisis.
• Since the subprime mortgage crisis, lending standards have tightened. However, subprime mortgages are still available to borrowers with poor credit histories. Borrowers who are considering a subprime mortgage should carefully consider the risks involved before taking out a loan.

LIBOR MANIPULATION

• In 2012, an investigation into the London Interbank Offered Rate (Libor) uncovered a scheme by multiple banks to manipulate Libor rates for profit. This scheme involved submitting false or misleading information about the rates at which banks were willing to lend to each other.
• One of the key players in the scheme was Barclays. Barclays employees would submit Libor estimates that were lower than the actual rates they were paying. This made it appear that Barclays was in a better financial position than it actually was, which could have helped the bank to attract investors and borrowers.
• Another bank that was involved in the scheme was UBS. A trader at UBS, Thomas Hayes, managed to make hundreds of millions of dollars for the bank by manipulating Libor rates. Hayes also colluded with traders at the Royal Bank of Scotland (RBS) to rig Libor.
• The Libor scandal had a significant impact on the financial industry. It led to a loss of confidence in Libor as a benchmark interest rate, and it also resulted in a number of fines and settlements for the banks involved.
• The Libor scandal revealed that a number of banks had been manipulating Libor rates for profit.
• The scandal led to a loss of confidence in Libor and it also resulted in a number of fines and settlements for the banks involved.
• The scandal has raised questions about the need for reform of the financial industry.

WHO IS SUCCEEDING LIBOR?

SOFR Is Replacing Libor in the U.S.

• It's not just these scandals that undercut Libor. According to ICE, banks have been changing the way they transact business, and, as a result, Libor rate became a less reliable benchmark.
• 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.
• These transactions take the form of Treasury bond repurchase agreements, otherwise known as repos agreements. They allow banks to to meet liquidity and reserve requirements, using Treasurys as collateral. SOFR comprises the weighted averages of the rates charged in these repo transactions.

WHAT'S THE SCENARIO IN INDIA?

• With the end near for the London Interbank Offered Rate (Libor), the Reserve Bank of India (RBI) told banks and other financial institutions to stop using the benchmark as soon as possible and move to any Alternative Reference Rates (ARR). Secured Overnight Financing Rate (SOFR) and Sterling Overnight Interbank Average Rate (SONIA) are the two popular alternatives, but are nowhere near as popular internationally as Libor, which is being phased out by this year's end.
• With the demise of Libor, the popular Indian benchmark Mumbai Interbank Forward Outright Rate (MIFOR), which uses Libor as a benchmark, is now scrapped too.
• Banks and financial institutions will have to undertake a comprehensive review of all direct and indirect Libor exposures and put in place a framework to mitigate risks arising from such exposures on account of transitional issues, including valuation and contractual clauses, the RBI said, adding the banks must also put in place the necessary infrastructure to be able to offer products referencing the ARR.
• The Financial Benchmarks India Pvt. Ltd. (FBIL) has ceased to publish MIFOR after June 30, 2023 and banks and financial institutions has taken all necessary steps to ensure insertion of fallbacks at the earliest in all remaining legacy financial contracts that reference US dollar Libor.

Hopefully this write-up was helpful for the readers, your feedbacks would be genuinely appreciated.

The author can also be reached at cagyatigupta@gmail.com