End of LIBOR era -- Bangladesh should prepare from now on

LIBOR (London Inter Bank Offered Rate) is the most popular and worldwide accepted benchmark rate in determining loan pricing in multiple currencies. Libor was first introduced in1986 when the BBA (British Bankers' Association) launched official commencement of this rate initially in only three currencies viz., US Dollar, GBP and Japanese Yen. Since inception in 1986, this reference rate has not only gained immense popularity but also dominated the world credit market. This rate has covered most debt markets in the world and almost all internationally accepted currencies. About USD 300 trillion loans which include almost all forms of credit ranging from personal loan to corporate loan and even LCs / SBLCs (standby LCs) are priced using Libor. Banks responsible for calculating Libor, commonly known as panel banks, report Libor to British Bankers' Association which averages this rate and releases every business day at 11.45 a.m. However, IBA, Intercontinental Exchange-Benchmark Administration, took over this responsibility form IBA in 2014. After playing dominant role in the world credit market during last three decades, this worldwide accepted reference rate popularly known as Libor is going to die by the end of 2021.

SETBACK IN LIBOR HISTORY: In the history of Libor, this world-famous benchmark rate faced severe setback in 2014 when manipulation of Libor was reported. During 2012-14 period, some Forex traders resorted to huge manipulation by posting inflated rate and took undue advantage in their favour. Consequently, about three hundred trillion US dollar loans which are priced using Libor was wrongly priced and as such badly impacted. This unprecedented manipulation occurred when world financial market was scrambling hard to recover from the worst-hit financial crisis that erupted in 2008 in the USA and subsequently swept across the world. This Libor scandal came as a great shock to the policymakers of world financial market, particularly USA and Europe. Because of strong persuasion from US regulator-- US Commodity Trade commission, this Libor manipulation was tried in the UK court where the main accused, a British trader, was sentenced with imprisonment. Many bankers involved with this manipulation were fired and some large banks which were allegedly involved with this manipulation were also severely punished with huge monetary penalty. After this Libor debacle, the death of Libor was thought to be imminent. Think-tanks and market experts were almost certain that at least the USA will not accept it and will come up with alternative rate because lion's share of international borrowing including US market is denominated in US dollar and priced using Libor. In 2014, US central bank, Federal Reserve, commissioned ARRC (The Alternative Reference Rate Committee) with the responsibility of recommending an alternative benchmark rate to USD Libor or Short-term reference rate for dollar denominated debt. Finally, Fed began publishing SOFR (Secured Overnight Funding Rate) in 2018.

EXPECTED VARIOUS REFERENCE RATES IN LIEU OF LIBOR: Although Libor transition has not formally started yet, leading financial markets, especially developed countries and renowned financial institutions have undertaken massive preparatory measures well ahead of Libor ending deadline so that transition can be made smooth without any interruption in loan pricing. Active discussion on some potential reference rates are already in the market and these are SOFR, SONIA, ESTER, TONAR, SARON. SOFR, Secured Overnight Funding Rate, will replace USD Libor. SONIA, Sterling Overnight Indexed Averaged Rate, will replace GBP Libor. TONAR, Tokyo Overnight Averaged Rate, is expected to replace TIBOR (Tokyo Interbank Offered Rate) in both JPY Libor and Euro-Yen. ESTER, European Short-Term Euro Rate, is going to replace EURIBOR (European Inter Bank Offer Rate) and EUR-Libor. SARON, Swiss Average Rate Over Night, is expected to replace Swiss currency LIBOR rate. Among all these replacing reference rates, SOFR will be the most important and demanding rate as most international trade is settled in US Dollar which is related to SOFR. In addition, ESTER, SONIA and TONAR are expected to play important role in pricing loans and settling payment in the global financial market.

DIFFERENCE BETWEEN LIBRO AND SOFR: There is a market perception that SOFR is expected to be as popular as LIBOR in determining loan pricing, but both rates not the same at all, rather different in many respects. LIBOR is known as term-based rates which are quoted from daily to one year perod. There are various LIBORs e.g., daily LIBOR, weekly LIBOR, 30 days LIBOR, 3 months LIBOR, 6 months LIBOR and one-year LIBOR, whereas, SIBOR is a daily rate. Libor rates are set and published two business days prior to the value date. If loan's drawdown date is Wednesday, Libor for that loan is set on preceding Monday, so any borrower requiring to draw in Libor, must serve drawdown notice at least three days prior to rate setting date to the lender. On the other hand, SOFR will not have this scope as this rate is set and published daily. Libor is calculated based on available market data, particularly available loanable fund held by the participating banks, judgment on market data, research and prediction made by the market experts while SOFR is determined entirely based on market data believing that there is no scope or very little scope of speculation. In fact, Libor is the average cost of borrowing whereas, SOFR is a risk-free rate based on treasury. In addition, Libor is known as unsecured rate while SOFR is known as secured rate where treasury balance is always considered as collateral.

CONSEQUENCE OF LIBOR TRANSITION: Transition of every event goes through some consequences regardless of positive or negative and likewise, Libor transition is not out of that usual course. However, what would be eventual consequence of Libor transition specifically-- whether borrower or lender will be positively or negatively impacted is not known yet. Now question, arises-- to what extent effective interest will be impacted from both borrower's as well as lender's perspective. Answer to this question completely depends on post-Libor market behaviour. So far, it is learnt that all available successor reference rates are overnight rates that would be calculated daily as opposed to term calculation under Libor. Overnight rate always results in higher amount than that of term rate which can be simplified with one hypothetical example. As for example, at the deadline of Libor transition, prevailing one-month Libor and SOFR rare are found the same, 125 bps. If outstanding one million US dollar loan remains one month to mature, total interest applied at SOFR with daily accumulation will generate USD 1,028 while 30 days Libor being the same as 1.25 per cent will generate USD 1,027. Difference apparently looks like very insignificant i.e., only one dollar. However, if outstanding loan amount is enormous which is very natural and if SOFR unusually moves up due to adverse market condition, this difference will of course be a considerable amount. Besides, Libor is only one factor in determining loan pricing denoted as AIR (All in Rate), which includes Libor as reference rate and spread which is fixed based on the borrower's credit standing and relationship with the borrower. So, in post-Libor era, what would be the spread for calculating AIR is also an important issue.

FALLBACK CLAUSE: In order to avoid complexity and confusion likely to arise during the transition from LIBOR to SOFR or other available reference rates, regulators of many countries have already advised their borrowers and lenders to include fallback clause in the credit agreement or LC / SBLC terms. This clause will be referred and used to resolve any dispute arising between the lender and borrower over the replacement of Libor rate, calculation thereof and payment term. So, this clause, if inserted in the credit agreement and LC or SBLC, will be very crucial and as such should be reviewed with careful attention prior to signing any relevant document. Especially, which rate will replace Libor, what would be the calculation term, payment or accumulation term, any maximum rate cap in the event of unusual behaviour of daily rate must be negotiated properly before executing the agreement. More importantly, all parties concerned should carefully look into whether interest will be compounded i.e., calculated daily and accumulated with loan amount to determine new loan balance for charging interest on the following day. Because, this may result considerable difference in interest amount that may trigger dispute between borrower and lender. Further, consideration should be given to the applicability of spread.

PREPARATION FOR BANGLADESH: Regardless of the expected consequence from Libor transition, it is obvious that Libor era will end after 2021. From 2022 onward, all new loans and LCs / SBLCs will be priced differently in addition to carrying out entire outstanding loans and LCs / SBLCs with switching Libor to new interest rate. For this exercise and successful transition, preparation is needed. Regulators of many countries irrespective of developed and developing world and many financial institutions have already initiated Libor transition process. Many committees and coordinating bodies have already been formed. Bangladesh Bank should maintain liaison with those committees/ bodies, undertake preparatory measures and properly guide market players involved in handling transactions using Libor. It is true that the scope of borrowing loans at Libor is very limited in our country. However, BB's recent move of relaxing Foreign Exchange Regulation may encourage many reputed corporate borrowers with good credit standing to borrow loan at Libor because of taking advantage of historically low interest rate from the world financial market. If this loan is continuous in nature and expected to continue in the post-Libor era, some precautionary measures should be put in place in order to face any adverse consequence, arising out of switching the rate. Apart from this, in international trade finance transactions particularly import / export business, LCs always stipulate the condition of applying Libor rate to calculate interest on usance period for negotiating or discounting documents under LC. In many situations, deferred payment LCs with long term tenure even up to one year are very common in our country because these are suppliers' credit categorically extended by the exporters abroad. Calculation of interest using Libor on this type of LC is a regular feature of deferred LCs. If outstanding LCs of this type are carried over the transition period, then Libor and switching thereof will of course become an issue which may trigger dispute. So, our regulator should be well prepared.

Nironjan Roy is a banker based in Toronto, Canada.

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