Originally used as a benchmark for inter-bank lending, the London Inter-Bank Offer Rate (LIBOR) has, since the late 1980s, been used as one of the standard benchmark rates for a variety of financial instruments including derivative products, corporate loans, credit cards and government issued instruments. Presently, approximately USD 350 trillion worth of financial contracts are linked to LIBOR. However, on account of declining unsecured and wholesale interbank borrowings, lack of transparency and the 2012 market disruptive event involving LIBOR, market participants have lost confidence in this otherwise widely used benchmark rate.
The LIBOR regulator, the United Kingdom’s Financial Conduct Authority (FCA), announced in 2017 that LIBOR would be discontinued by December 2021. Accordingly, developed economies, such as the UK and the United States have set up various committees to explore, develop and assist in adoption of an alternative risk-free reference rate, whereby moving away from inter-bank offered rates (IBORs) entirely.
The primary difference between IBORs and other alternative risk-free reference rates are:
- Expert judgment: IBORs are forward-looking benchmarks, which are heavily dependent on expert judgment. On the other hand, alternative risk-free reference rates are backward looking rates, which are calculated on basis actual overnight transactions that take place outside market hours. In other words, IBORs are based on estimated rates, whereas other alternative risk-free reference rates are based on actual trades.
- Secured versus unsecured: IBORs are bank-to-bank lending rates which are unsecured whereas, other alternative risk-free reference rates are secured and usually collateralised by treasuries.
Over the last half a decade, various alternatives to IBORs have emerged, including the likes of Secured Overnight Financing Rate (SOFR), Sterling Overnight Index Average (SONIA), Euro Short-Term Rate (ESTR) and Tokyo Overnight Average Rate (TONAR).
As we inch closer to the December 2021 deadline, one can expect the market to witness detailed deliberations on this topic given that the fundamental basis on which IBORs are calculated is significantly different from that applied for other alternative risk-free reference rates such as SOFR, SONIA, ESTR and TONAR. Banks and other financial institutions across the globe have begun the process of reassessing pricing of various products and unlinking them from LIBOR and other IBORs.
Amendments proposed by the Asia Pacific Loan Market Association (APLMA) and dealing with ‘tough legacy’ contracts
Template clauses for replacement of the benchmark rate and screen rate have been released by APLMA. These are in the nature of ‘enabler clauses’ which allow for relevant amendments to be made when a new benchmark rate will replace LIBOR.
APLMA is also in the process of preparing a US dollar SOFR based term loan facility agreement, which will be in two forms:
- the first will employ the Alternative Reference Rates Committee (ARRC) recommended ‘Simple Daily SOFR’ convention in line with recent ARRC/Loan Syndications and Trading Association (LSTA) recommendations; and
- the second will employ the Loan Market Association (LMA) recommended ‘compounded average in arrears’ convention.
On 21 October 2020, the UK Government introduced the Financial Services Bill (‘FS Bill’) in the UK parliament to deal with, inter alia, ‘tough legacy’ contracts.
The FS Bill aims to reduce the risk of litigation arising from disputes about the continuity of ‘tough legacy’ LIBOR contracts.
While the FS Bill does not define the term ‘tough legacy’ LIBOR contracts, the policy statement accompanying the FS Bill confirms that HM Treasury and the FCA are of the view that this exemption is intended for those contracts that genuinely have no realistic ability to be renegotiated or amended to transition to an alternative benchmark. In other words, when LIBOR is at risk of becoming unrepresentative, or has become unrepresentative, and that its representativeness cannot be reasonably maintained or restored.
In such circumstances, the FCA will have the power to designate a change to the methodology by which LIBOR is set so that references in ‘tough legacy’ contracts to LIBOR will effectively be treated as a reference to the new methodology (the synthetic LIBOR rate), rather than a rate which no longer exists.
The FS Bill once passed, shall apply to all UK supervised entities and shall not be limited only to contracts governed by UK laws.
Steps taken in India
In the context of cross-border financings, a number of financial institutions, corporations, private equity firms, hedge funds and so on, will be impacted on account of the shift from LIBOR to other alternative risk-free reference rates. Most such entities have commenced the process of undertaking risk assessments, system updates and contractual amendments. A shift away from LIBOR will entail a different set of risks affecting external commercial borrowings, cross-currency swaps, LIBOR-linked interest rate swaps, corporate bonds, credit default swaps and even the LIBOR-based Mumbai Interbank Forward Offer Rate (MIFOR) contracts.
The issues in the Indian banking sector (and specifically in relation to domestic lending and borrowing transactions) are rather nuanced and specific, as we have traditionally used opaquely calculated internal benchmarks unlike more developed economies where the domestic lending rates are also linked to external benchmarks. Recognising this challenge, a few steps have been undertaken in India, a summary of which is provided below:
- The Reserve Bank of India (RBI) announced implementation of the recommendations of its Committee on Financial Benchmarks (the ‘Committee’) in the first bi-monthly monetary policy statement for 2014–15 on 1 April 2014. Basis the recommendations of the Committee, the calculation methodology of the FIMMDA-NSE overnight MIBID/MIBOR was changed from the extant polling-based method to an actual transaction-based method. To assist market makers (ie, banks and primary dealers) that were desirous of implementing the amendments described above, FIMMDA published a Multilateral Amendment Agreement (MAA). A bilateral version of the 2015-MAA was also published for market makers to use with their counterparties.
- In September 2019, pursuant to the recommendations of an internal study group and in consultation with relevant stakeholders, the RBI issued a circular (‘RBI Circular’) in relation to transitioning to an external benchmark rate. While this did improve monetary transmission, evolving market conditions remained outside the scope of consideration when calculating such rates. The RBI Circular aims at transitioning from base rate and marginal-cost-of-funds-based lending rate (MCLR) to external benchmarks for certain loan product categories. The key changes suggested pursuant to the RBI are:
- All new floating rate for personal or retail loans (housing, auto, etc) and floating rate loans to micro and small enterprises extended by banks from 1 October 2019 shall be benchmarked to one of the following: (a) Reserve Bank of India policy repo rate; (b) Government of India 3-Months/6-Months Treasury Bill yield published by the Financial Benchmarks India Pvt Ltd (FBIL); or (c) any other benchmark market interest rate published by the FBIL.
- While it is not mandatory, banks may consider using external benchmarks for other loans as well.
- Only a single benchmark can be adopted for a particular loan category and lending below the set benchmark rate is not permitted. This shall achieve the objectives of transparency, standardisation and ease of understanding of loan products by borrowers.
- Banks are free to decide the spread over the external benchmark. However, credit risk premium may undergo change only when a borrower’s credit assessment undergoes a substantial change, as agreed upon in the loan contract. Further, other components of spread including operating cost could be altered once in three years.
- Existing loans and credit limits linked to the MCLR/base rate shall continue until repayment or renewal, as the case may be.
- The Indian Banks’ Association has also officially communicated to the Federation of Indian Chambers of Commerce and Industry (FICCI), Confederation of Indian Industry (CII) and Associated Chambers of Commerce (ASSOCHAM) to prepare for the phasing out of LIBOR.
- Additionally, with the aim of easing the transition, the Indian Banks' Association has established a working group on LIBOR transition and is in the process of developing a guidance note for banks in India. At ground level, various banks have formed internal steering committees and special task forces across departments, to evaluate risks, identify alternative benchmarks, create term structures and evaluate legal and financial implications of this transition.
Moving towards a seamless transition
India has already reformed its domestic benchmarks by setting up FBIL and ensuring a smooth migration by market participants to the new benchmarks administered by FBIL. In that sense, the non-borrowing market in India is ahead of the game!
In the context of domestic commercial lending and borrowing transactions, presently, each bank in India (whether public or private) publishes its own MCLR (the bare minimum rate below which banks in India cannot lend money). Being an internal benchmark, this rate differs from bank to bank. Additionally, banks also have the discretion to apply a margin/spread component as a part of their interest calculations.
Agreeing to migrate to an external benchmark for commercial loans may result in banks being bound by a single rate applicable across the board. Given that presently MCLR is different for each bank, this may not necessarily make commercial sense. The broader question to be asked is, do banks really need to migrate to an external benchmark for domestic commercial lending and borrowing transactions? If the RBI did indeed intend on mandating banks to adopt an external benchmark for such commercial lending and borrowing transactions, would it not expressly state so in the RBI Circular?
RBI is perhaps clear insofar as its intention is concerned. The RBI Circular only mandates migration to an external benchmark as regards certain loan categories (personal, retail and loans to micro and small enterprises). Banks do have the discretion to adopt an external benchmark for other loans, but this is not a mandatory requirement. Only time will tell whether banks will look at migrating towards an external benchmark for domestic commercial lending and borrowing transactions.
As regards transitioning of cross-border financing arrangements from IBOR (including LIBOR) to an alternative risk-free reference rate, such transition will largely be guided by steps taken by the financial authorities (eg, FCA, APLMA, etc).
In conclusion, as John Williams, President of the New York Federal Reserve once said, ‘Some say only two things in life are guaranteed: death and taxes. But I say there are actually three: death, taxes and the end of LIBOR.’