Law Firm in India

RBI Advisory on the Transition of LIBOR

The Reserve Bank of India issues advisories to banks and their customers regarding new benchmarks in the market and the closure of LIBOR.

The UK Finance Conduct Authority announced on 5th March,2021 that it will stop approving the LIBOR for Pound sterling, Euro, Swiss franc and Japanese yen settings, and the 1-week and 2-month US dollar settings with effect from 1st January 2022 and remaining US dollar settings, Libor rates will cease with effect from 1st July 2023.

Post this announcement of FCA, Reserve Bank of India (RBI) issued an advisory on June 8th, 2021, to the banks and other RBI regulated entities or their clients to stop entering into new contracts that use LIBOR as a reference rate (as soon as practicable) and latest by 31st December 2021.

After the publication of this advisory, there has been a lot of commotion in the market regarding the new benchmark SOFR, its functions and the LIBOR scandal. This article primarily explains the concept of LIBOR, the scandal involving LIBOR, government issued advisory as well as details regarding the new alternative benchmark SOFR.
Concept of LIBOR
  • LIBOR stands for London Interbank Offered Rate, and it represents the average rate at which global banks are willing to one another in the international market for short term loans. It was conceptualized in 1969 and officially announced by the British Bankers Association (BBA) in 1986. LIBOR is currently the world’s most widely used benchmark interest rate for financial and non-financial contracts and plays a critical role in the US$400 trillion financial contracts worldwide.
  • LIBOR is calculated by the method of polling. At a specific time, an official from the intercontinental exchange calls up about 16 to 18 major banks (like Bank of America, Barclays Bank, Citi Bank, Credit Suisse) and gathers quotations for their charge rates if they are to lend money for short term loans for seven different maturity periods. The official then consolidates their quotations and adds their own spread percentage and finally release the LIBOR rates for multiple currencies across 7 different maturities ranging from one day to 12 months.
  • LIBOR SCANDAL- In a perfect world, the calculation of LIBOR is perfect, but that’s rarely the case when it comes to real world. The flaw in derivation of LIBOR imperfection came to light with the eruption of so-called LIBOR scandal in 2012 which sent massive shockwaves across the finance market globally. The major bank players colluded amongst themselves and manipulated the LIBOR rates for their own benefit by quoting mutually decided rates to the market officials. Once this scandal broke out, there was a massive outrage amongst people of the financial world, because people’s faith and belief in the unbreakable and inviolable processes of the financial world was shattered. Some of the main players who were involved in the scandal were Citi Bank, HSBC, Barclays bank, Deutsche Bank, JP Morgan.
Once the scandal broke out, people felt it was time for LIBOR to exit and make its way for a new alternative benchmarking process. But replacing LIBOR is not very easy thing as almost all of the exiting loans are benchmarked using the LIBOR rates.
Alternatives of LIBOR

A committee was convened by the federal government known as the ARRC (Alternative Reference Rate Committee) to come up with suggestions for alternatives. Some of the alternatives for LIBOR are Sterling Overnight Index Average (SONIA) by the United Kingdom, Secured Overnight Financing Rate (SOFR) by the United States and Japan’s Tokyo overnight average rate (TONAR) by Japan.

Presently, every major market has developed its own benchmark like India has- MIBOR (Mumbai Interbank Offer Rate), also Pakistan has- KIBOR (Karachi Interbank Offered Rate) however till yet, no benchmark has been internationally standardized and globally accepted by all countries.
Impact of LIBOR transition on banks & companies
LIBOR is a very old systematic and well-run international interest benchmark, but in order to use the new benchmark say SOFR, banks would have to update their systems and agreements which would cause a great deal of trouble as they would have to now benchmark the loans again by the end of fiscal year using a new exchange rate.
Along with these technical issues there are multiple problems for banks and financial companies after discontinuation of LIBOR. Some of them are listed below:
  • If the agreement is based on the LIBOR and the maturity date is after the 31st of December 2021 then, what will be the consequences of that agreement and how we can amend the historical agreement under fallback clause.
  • If an agreement is made after ceasing of LIBOR, then which alternative reference rate will be use for the short-term loan transactions.
  • LIBOR interest rate used also fluctuated & changed regularly. Now the concern will arise regarding the uncertainty of transitions and the new benchmark rate.
  • Most of the countries and banks has chosen their new benchmark as SONIA or SOFR but still there is a confusion to choose the new benchmark for many companies and banks.
The Advisory of Reserve Bank of India (RBI) on LIBOR transition
The Reserve Bank of India post UK Finance Conduct Authority announcement has issued the advisories to the banks and their clients along with assurances that they are trying to find a solution for the impact the discontinuation will have on the financial sector. As per their statement, they will encourage banks and their clients to ensure that new contracts entered before 31st December 2021 that reference LIBOR and whose maturity is after the date on which LIBOR ceases include Fallback Clauses.
The Fallback Clause here refers to the clause that defines the process through which the replacement rate can be identified if a benchmark is not available or exist. Fallback language comprises three key components: trigger event, benchmark replacement, and benchmark replacement adjustment.

For the amendment of historical/existing loan agreements or for the new agreement post the LIBOR ceasing, we can go through the fallback clause of the agreement and try to mention some points based on benchmark replacement adjustment or related to new benchmarks.

If there is no fallback language clause in the existing loan agreement, its then required to identify and cover the following areas-

-        Identification of new benchmark rate,
-        Identification of post-adoption financial risks involved in using the new benchmark.
-        Identification of legal risk involved post the adoption of the new benchmark
-        Identification and analysis of the compliances which needs to be adhered  post the adoption of the new benchmark.
1. Encourage the banks and their clients to cease entering new financial contracts that reference LIBOR, as well as the Mumbai interbank forward outright rate (MIFOR), which references the Libor, as a benchmark.
The Alternative Reference Rates (ARR) such as Sterling Overnight Index Average (SONIA) by the United Kingdom, Secured Overnight Financing Rate (SOFR) by the United States and Japan’s Tokyo overnight average rate (TONAR) by Japan already been adopted by various institution.

On the basis of this advisory we could go for different alternatives of LIBOR, and it totally depends on the money lender bank as to which alternative they are using following the advisory of RBI. Some of the major Indian banks like - SBI, ICICI etc. have started using SOFR in place of LIBOR. And few big companies are also going towards the United States Benchmark SOFR. Hence, it is safe to conclude that choosing an alternative of LIBOR is up for choice as it totally depends on the rate of that particular benchmark and also the total of spread percentage of the bank.
2. Banks may trade in MIFOR with effect from 1st January 2022 only for certain specific purposes such as transactions executed to support risk management activities such as hedging, require participation in central counterparty procedures, market-making in support of client activities etc.
Banks and their clients can trade with The Mumbai Interbank Forward Offer Rate (MIFOR) without dealing on the basis of LIBOR, only to cover specific risks activities.
3. Banks are mandated to make a comprehensive review of all the direct and indirect LIBOR exposures and define a framework to mitigate the risks arising from such exposures. The exposures can be on account of transitional issues including valuation as well as contractual clauses. The Banks may also create the necessary infrastructure which can offer products referencing the ARR. In this context, the continued efforts made by organizations to sensitise clients about the transition and convention changes involved in the alternatives to LIBOR will be their key focus area.
The banks require to perform all the steps which are necessary to mitigate future risk due to LIBOR exposures whether they are direct or indirect. Banks should make a proper basic structure regarding new benchmarks rates and to mitigate the risk of LIBOR transitions.
4. Banks must urge to incorporate robust fallback clauses, preferably well before the respective cessation dates, in all financial contracts that reference LIBOR and the maturity of which is after the announced cessation date of the respective LIBOR settings.
5. Banks may refer to the standard fallback clauses developed for this purpose by various agencies such as International Swaps and Derivatives Association, Indian Banks’ Association, Loan Markets’ Association, Asia Pacific Loan Markets Association and Bankers Association for Finance & Trade.
Discontinuation of LIBOR is definitely a huge setback for the financial market, and it will take us a while to settle on an alternative standardized benchmark for the same. Currently there are so many questions arising on the ceasing of LIBOR like- Which alternative can provide the global longer-term rate in market as LIBOR did and will the new alternative provide 6-month & 12-month rates just as LIBOR did and much more. The answers to these questions are currently unknown to us. We are in unchartered territory right now and only with time can we answer these questions on standardized alternatives and the evolution of their long-term rates.

If we talk about the existent loan agreements which are already benchmarked to LIBOR that in most of these contracts, there is a Fallback language clause which only covers the situation if there exists a temporary lapse in the publishing of LIBOR. Bur banks have now been instructed to have a stronger fallback clause in the agreements which can provide for the entire substitution of an existing benchmark to a new benchmark. Given the situation, it is quite possible that the benchmark could co-exist for a particular period of time. Whatever be the scenario, it promises to be quite an interesting period till 2023 to see the entrances of the new global benchmarks into the market. Till that time, we are following the guidelines of RBI and figuring out the solutions under the advisories.

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