RBI tells banks to complete transition from LIBOR
19th May, 2023
The Reserve Bank of India (RBI) has asked banks and financial institutions to adopt by July 1 a widely accepted Alternative Reference Rate, such as the Secured Overnight Financing Rate (SOFR), to complete the transition from the scandal-hit London Interbank Offered Rate (LIBOR) and Mumbai Interbank Forward Outright Rate (MIFOR).
- LIBOR was being used as the benchmark rate for raising funds abroad.
- It was a key benchmark for setting the interest rates charged on adjustable-rate loans, mortgages and corporate debt.
LIBOR: Why is it being retired?
- LIBOR is being phased out because of the role it played in worsening the 2008 Financial Crisis, as well as scandals involving LIBOR manipulation among rate-setting banks.
- In 2012, investigations into the way LIBOR was set uncovered a widespread, long-lasting scheme among multiple banks to manipulate rates for profit.
What’s the alternate?
- In place of LIBOR, the Secured Overnight Financing Rate (SOFR) serves as the benchmark interest rate for loans and derivatives denominated in dollars.
- New transactions are now predominantly undertaken using SOFR and the Modified Mumbai Interbank Forward Outright Rate (MMIFOR).
- SOFR is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.
- Accuracy: Unlike LIBOR, SOFR is based on actual transactions — namely, overnight transactions in the Treasury repo market. Thus, SOFR is a more accurate means of measuring the cost of borrowing money. Because these transactions can be observed by anybody, it’s also less easily manipulated.
- Risk: SOFR is based off of overnight Treasury transactions, it’s considered to be a risk-free rate.
- Finalization of loan cost: Financial institutions utilize SOFR as a benchmark when determining the cost of consumer and business loans.
- In addition, it is essential in trading derivatives, especially interest-rate swaps, which businesses and other parties use to manage interest-rate risk and speculate on changes in borrowing costs.
What is Overnight Rate?
- The benchmark interest rate that depository organizations like banks and credit unions charge one another for lending money for a single night is the Overnight Rate.
- It is closely related to banking operations and liquidity issues. This rate has different names depending on the country.
- For example, it is referred to as the Marginal Standing Facility Rate in India.
What is the impact of change in the Overnight Rate?
- Direct influence on economy (high rate): The Overnight Rate may indirectly affect mortgage rates if it rises. When the Overnight Rate is high, it is expensive for banks to pay off their debts. Thus, they raise the rates on long-term loans to make up for the high Overnight Rates, which in turn directly impact the country’s employment, economic growth, and inflation.
- Economic expansion (low rate): On the other hand, when the rate is low, banks and other financial organizations can lend and borrow more frequently, promoting economic expansion.
- Also, lower Overnight Rates suggest that consumers and businesses will have easier access to loans. As a result, the commercial sector expands due to the additional cash business expansion and investor attraction. The purchasing power of consumers likewise rises when commercial activity expands.