Lessons for India from LIBOR Transition
Global experiences on developing an effective reference rate as an alternative to LIBOR could guide our future benchmark reforms
John C. Williams, president at the Federal Reserve Bank of New York, joked at the 2019 US Treasury Market Conference: “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.”
The London Interbank Offered Rate (LIBOR) transition is a landmark event, and most discussions in India have focussed on the impact. The lessons the LIBOR transition holds for Indian benchmark reforms are more interesting.
LIBOR is the benchmark rate for an estimated $400 trillion worth of derivatives, loans, and other financial instruments. Until 2013, LIBOR was an average of polled rates from a panel of banks and represented the unsecured rate at which banks said they could borrow from other banks.
After the global financial crisis, trades dried up in the interbank market as banks grew uncomfortable lending to peers because of an increased perception of credit risk. LIBOR submissions became more reliant on the expert judgement of a small set of banks, and widespread rigging was unearthed; fines imposed on banks worldwide from the resulting LIBOR scandal totalled more than $9 billion.
Moving away from LIBOR
Resulting regulatory reviews focussed on two aspects: (1) reforming LIBOR during the transition period, and (2) developing alternative reference rates (ARRs) for transition from 2021.
From January 2014 onwards, LIBOR’s methodology was changed to reflect a wholesale funding rate anchored in transactions to the greatest extent possible, using a standardised transparent methodology, and to reduce expert judgement.
The ARRs identified for key global currencies are overnight nearly risk-free rates which reflect wholesale transactions from financial institutions. The rates can be unsecured — such as the Sterling Overnight Index Average (SONIA) — or secured — such as the US Secured Overnight Funding Rate (SOFR) — and the choice is made on the basis of the liquidity and structural features of underlying money markets.
ARRs are an accurate representation of money market interest rates. But they fall short of being a true discount rate for pricing derivatives of longer maturities or a benchmark for bank lending because of the lack of a robust term structure. The development of forward-looking term structure continues to be an area of focus.
India’s estimated $435 billion of external borrowings at the end of 2019 and derivatives linked to the Mumbai Interbank Forward Offer Rate (MIFOR) — which is derived from USD LIBOR — will be affected. The transition playbook is relatively straightforward and follows the LIBOR transition to ARRs.
Issues associated with domestic lending rates are more nuanced. Unlike banks in the industrial world, which offer loans based on external reference rates, Indian banks have long used internal benchmarks like the marginal cost of lending rate, base rate, and the benchmark prime lending rate, which have lacked transparency and constrained monetary transmission.
Last September, the Reserve Bank of India mandated that banks transition to an external benchmark, which can be a policy repo rate, T-bill rates, or other money market benchmarks. In response, most banks transitioned to the policy repo rate as the benchmark of choice.
While this improved monetary transmission, a policy rate does not reflect evolving market conditions and would constrain future changes to the monetary policy framework. In the United States, concerns were raised when Fed actions had a huge influence on the SOFR, despite it being a market-determined rate. It was felt some distance was needed between policymakers and market rates.
An ideal lending benchmark has several desirable properties, including reliability, liquid term structure, relationship with banks’ marginal cost of funds, and a high correlation with policy rates. None of the current external benchmark options meets all of the criteria. To get to an ideal benchmark, we should coalesce around one option and improve it over time; the Bank of England’s recent reform of SONIA to improve liquidity by expanding the scope of transactions is a case in point.
It is desirable for this to be market-participant driven process with active regulatory guidance. The Active Reference Rates Committee, composed of private market participants and convened by the New York Fed to ensure a smooth transition from USD LIBOR to SOFR, is another example.
In addition to lending benchmarks, another potential area for reform is the MIFOR, an interest rate derived from foreign currency interest rates and forward currency premia. MIFOR is an admittedly inelegant solution for currency hedging compared with a cross-currency basis curve, and yet it is an artefact of history.
The LIBOR transition will happen in the near future, despite extraordinary market conditions delaying most other financial reforms. In the process, several countries have grappled with and settled on their reference rate choices and have come out with transition plans. Their experiences hold valuable lessons for future Indian benchmark reforms.
Subrahmanyam OV, partner, FS Risk Advisory at E&Y, contributed to this article.
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