What is LIBOR and why RBI has asked the banks to Move away from it

Context: The Reserve Bank of India has directed the banks and other financial institutions to move away from the LIBOR (London Interbank Offered Rate) and move to any Alternative Reference Rates (ARR).

What is LIBOR?

LIBOR stands for the London Interbank Offered Rate. It is a benchmark interest rate that indicates the average rate at which major banks in London are willing to borrow from each other in the interbank market. LIBOR serves as a reference rate for a wide range of financial products and transactions, including loans, derivatives, and other financial contracts.

  • The British Bankers’ Association (BBA) used to administer LIBOR until 2014, after which the Intercontinental Exchange Benchmark Administration (ICE Benchmark Administration) took over the responsibility.
  • LIBOR is calculated for various currencies and different borrowing periods, ranging from overnight to one year.
  • The calculation of LIBOR involves a panel of major banks submitting their borrowing rates, which are then used to determine an average rate. These rates are supposed to reflect the rates at which banks can borrow funds in the London wholesale money market.

How Is Libor Calculated?

  • 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.
  • To safeguard against extreme highs or lows, the Intercontinental Exchange (ICE) Benchmark Administration strips out the four highest submissions and the four lowest submissions before calculating an average.
  • 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.

Libor Scandals and the 2008 Financial Crisis

  • During the crisis, banks manipulated the LIBOR rates for their own benefit. They understated or manipulated their reported rates to create an illusion of financial health and to appear more creditworthy than they actually were.
  • By manipulating LIBOR rates, banks were able to lower their borrowing costs and increase their profits. This also gave them a false sense of security and credibility in the eyes of investors and counterparties.
  • The manipulation of LIBOR distorted the true pricing of financial products, leading to mispricing and increased risk in the global financial system.
  • Many financial institutions around the world relied on LIBOR as a benchmark for pricing and valuing their financial products. The manipulation of LIBOR undermined the integrity of these markets and eroded trust among market participants.
  • The impact of the LIBOR manipulation was far-reaching. It affected trillions of dollars’ worth of financial contracts globally, including loans, mortgages, and derivatives. This, in turn, had a significant impact on individuals, businesses, and the overall economy.
  • The revelation of the LIBOR manipulation sparked a wave of investigations, lawsuits, and regulatory actions against banks involved in the scandal. Several major financial institutions faced substantial fines and penalties for their involvement.
  • The 2008 financial crisis exposed the vulnerabilities and weaknesses in the LIBOR benchmark system. It highlighted the need for reform and the development of alternative, more robust benchmark rates to ensure the integrity and stability of financial markets.
  • In response to the crisis, efforts were made to transition away from LIBOR as a benchmark rate. Various alternative reference rates, such as the Secured Overnight Financing Rate (SOFR) in the United States, were introduced to replace LIBOR and mitigate the risk of manipulation.

The RBI has directed all banks in India to end all contracts with LIBOR by 31 Dec and use the Mumbai Interbank Forward Offer rate (MIFOR).

What is MIFOR?

  • MIFOR stands for Mumbai Interbank Forward Offer Rate. It is a benchmark interest rate used in India to determine the pricing of various financial instruments, particularly forward rate agreements (FRAs) and interest rate swaps (IRS).
  • MIFOR is derived from a combination of the Mumbai Interbank Offered Rate (MIBOR) and the corresponding foreign currency benchmark rate. MIBOR is the interest rate at which banks in Mumbai, India, lend to one another in the interbank market.
  • The foreign currency benchmark rate used in the calculation of MIFOR depends on the currency involved in the transaction.
  • MIFOR is commonly used in India for hedging and pricing purposes in the derivatives market. It reflects the market’s expectations of future interest rates in India and provides a reference point for interest rate-related transactions.
  • It’s worth noting that the information provided is accurate up until my last knowledge update in September 2021. There might have been updates or changes in the financial landscape since then, so it’s always a good idea to consult up-to-date sources and experts for the most recent information.

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