As Libor End Nears, Indian Lenders And Firms Have Many Hoops To Jump Through
As the deadline for phasing out London Interbank Offered Rate nears, Indian banks, non-bank lenders and corporates are finding themselves at different stages of transition.
While some have started work to meet the December-end deadline, others are yet to begin the process. A majority are in the initial stages of shifting existing and new contracts to alternative reference rates that will replace Libor.
“Barring a few large banks that are in advanced stages of their preparation, a large segment of the market, which includes mid-sized banks and non-banking financial companies, along with most of the corporates, are either in very initial stages or yet to begin the process of remediating their existing contracts,” said Kuntal Sur, partner and leader-financial risk and regulations at advisory firm PwC India. Sur is coordinating the working group set up by the Indian Banks Association to devise methodologies for a transition away from Libor.
While Libor is computed based on a poll of estimated borrowing rates and is a forward-looking rate, the new reference rates are backwards-looking based on actual transactions.
The transition away from Libor began after it was found to have been manipulated for years. The Intercontinental Exchange, which is the authority responsible for Libor, said it will stop publishing one-week and two-month U.S. Dollar Libor after Dec. 31, 2021, while rates for the remaining tenors will be discontinued after June 30, 2023.
Most of the the existing contracts and all the new contracts after December will need to move to alternate rates. However, since Libor rates for tenors other than one-week and two-months will be synthetically published, lenders and firms can choose to hold some ill-liquid contracts linked to Libor rates till June 2023.Kuntal Sur, Partner & Leader - Financial Risk And Regulations, PwC India,
What The Transition Involves
The transition from Libor to an alternative reference rate is a complex one.
The first step in this process has been to develop alternative rates. Some of these alternatives include U.S. dollar-based Secured Overnight Financing Rate, U.K.’s Sterling Overnight Interbank Average Rate, European Union’s Euro Short Term Rate, Switzerland’s Swiss Average Rate Overnight, and Japan’s Tokyo Overnight Average Rate.
Since Libor is going away by December, if a lender or a company wants to transition to an alternative reference rate, it needs to do the following:
- Prepare an inventory of impacted contracts. That’s easier said than done as Libor may be referenced in a wide variety of contracts, including lending arrangements, derivative contracts, leases, procurement contracts, or in a late payment penalty provision.
- Compute the spread or the difference between Libor and the new chosen rate. This could also lead to a material change in future cash flows and interest payments.
- Lay down a process for migrating to new reference rates. This process will have to cover all instruments such as floating rate debt, bilateral business loans, syndicated loans and securitisations.
- Renegotiate existing contracts with lenders, borrowers and other counterparties.
As a large portion of overseas borrowings for Indian lenders and firms is linked with U.S. Dollar Libor, it will have to be replaced by SOFR. The migration away from Libor would also need to happen for deposits in foreign currency non-resident bank accounts and derivative contracts.
The preparedness to make the shift differs widely.
With just eight more months to go, new deals linked to SOFR haven’t picked up much pace, and are only being done by some large banks through their overseas branches.
In January, State Bank of India and ICICI Bank Ltd. executed their first interbank-money market transactions linked to SOFR through their Hong Kong branches, followed by the country’s first SOFR-linked overseas borrowing transaction between SBI and Indian Oil Corporation Ltd. in March. Yes Bank Ltd. did its first SOFR-based trade finance transaction with Wells Fargo Bank in April.
New dollar bond deals in the coming quarter are likely to remain pegged to Libor for most corporates, said Ganeshan Murugaiyan, head of investment banking for India at BNP Paribas.
Currently most of the new overseas loan contracts are still pegged to Libor and we don’t expect a significant change for the pipeline for the coming quarter. However, the contracts have fallback or switch clauses so they can transition over to SOFR-based rates once Libor cessation happens.Ganeshan Murugaiyan, Head of Investment Banking - India, BNP Paribas
The process of shifting existing contracts is more onerous and slower.
For instance, Bank of India told BloombergQuint it’s yet to move its existing contracts to SOFR, as it awaits clarity on the methodology for migrating contracts.
“We’re still under preparation,” said PR Rajagopal, executive director at Bank of India. “The methodology is yet to be worked out by the IBA on how the differentials have to be captured in the agreements,” he said. “So once that methodology comes to us, then we will move our existing contracts.”
In the case of corporations, Sur said in the absence of a Libor transition plan, companies may be relying too much on banks for direction. “Corporates have to form an independent view and their own risk management strategy, otherwise they would be at mercy of the large banks— domestic and foreign, which would obviously first try to minimise the impact on their own P&L (profit and loss),” he said.
A senior executive at a large public-sector firm with close to Rs 45,000 crore in external commercial borrowings, said on the condition of anonymity that works on transitioning away from Libor contracts hadn’t even begun for his company, mainly due to business challenges during the pandemic. The company, he said, is expected to begin work on a transition plan in the next two months.
Some Unanswered Questions
To be sure, there are a few genuine reasons for the delays being seen.
First, hedging options are not available linked to the alternate reference rates. Second, re-negotiating and accepting the differentials between SOFR and Libor has been a contentious issue.
As the SOFR-Libor spread on cash products such as loan contracts is yet to be crystallised, even with a fallback mechanism in place for the new and existing Libor deals, the issue is the counterparty could challenge the spread difference, which could have been computed differently by both parties.Chalasani Venkat Nageswar, Deputy Managing Director, SBI
The RBI flagged off this issue in November. Renegotiation and conversion at wide spreads, it said, could lead to the requirement of substantial pay-outs by one of the counterparties to a contract.
“The transition away from Libor to a new benchmark will be full of challenges and every stakeholder—the financial sector; regulators; tax, legal and accounting systems; and real sector participants need to play a role,” the central bank had said.