It is important to get a sense of the cost of this change for Indian entities as well as RBI’s thought process on the benchmark to be used.
RBI’s recent Guidance to banks as well as companies calls for being cognizant of the fact that LIBOR will be going off the market from next year; it warns entities against getting into such contracts. More important, they need to handle contracts that are expiring post-2021. LIBOR is a sort of financial truth used globally for plethora of transactions. Once the LIBOR loses its sanctity, there is the question of how to handle the same.
There are two aspects. First, globally, there is already a large volume of outstanding transactions linked to LIBOR (around $223 trillion, of which $74 trillion could be maturing post-2023). The bulk is in derivative contracts—around $213 trillion. Second, even though the ICE Benchmark Administration (IBA) had announced that it would no longer be providing these benchmarks, several transactions were still reckoned.
Now, with the advice that all the transactions and contracts must be recalibrated to a new benchmark, the latter should ideally be an inter-bank rate. LIBOR gets into almost all risk models, valuation tools, and product design (even MIFOR of India is linked to LIBOR and will now fall out of use). Mortgage rates are set against the LIBOR. Market-players are looking at SOFR (secured overnight finance rate) as an alternative, as this was recommended by the Alternative Reference Rates Committee (ARRC). The fixing of spread adjustments by the International Swaps and Derivatives Association (ISDA) provides an economic link between LIBOR and selected risk-free rates (RFRs) for referencing contracts that expire after end-2021. But, any new benchmarking will mean that there will be losers and gainers, and the amounts involved may be large.
Once the reference is decided, there must be agreement on the basis (yield difference) between the old and the new benchmark. This can lead to considerable subjectivity, since, even though historical data can be used for creating these links, the robustness of this is questionable. SOFR is an overnight rate based on actual data and is not forward-looking, while LIBOR was for different tenures (of one day to one year) but based on market-experts’ opinion.
RBI had estimated in November 2020 that around $50 billion of debt and $281 billion in derivatives would expire after 2021. There are also government contracts that are linked with LIBOR. There is clearly a risk being carried by companies and banks on these contracts, as borrowings or deposits would directly get affected by the differences in cost that may arise when the benchmark is changed. Interest rate swaps (IRS) are benchmarked with MIFOR, which includes LIBOR.
Companies and banks would need to seek a hedge to counter potential losses. For new contracts, the players will know in advance the benchmark, say, the SOFR, and accordingly decide on pricing. The running contracts will be a concern. The $50 billion of debt would be equivalent of Rs 3.75 lakh crore and even a 0.1% variation can mean a potential loss of Rs 375 crore.
It will be interesting to see how RBI adapts to the absence of LIBOR. At present, all ECBs are benchmarked against the LIBOR, and companies are allowed to raise money at LIBOR-plus-a-certain-interest-rate. RBI’s decision will set the tone for others. RBI, of course, is not dealing with the LIBOR here, but merely using it as a reference point for commercial borrowings.
Taking this forward, the threat of risk posed to the financial system needs to be evaluated and it would be useful if banks are asked to make such disclosures as part of market risk carried and the mitigating measures. The same holds for companies which need to evaluate and state in their quarterly investor meeting the possible cost that would have to be borne on account of this transition. It is important to get a sense of the cost of this change for Indian entities as well as RBI’s thought process on the benchmark to be used.
The author is Chief economist, CARE Ratings
Views are personal