LIBOR - TRANSITION - Importance of "FALL-BACK" CLAUSES

The Financial Conduct Authority (FCA) announced that it would not compel banks to submit LIBOR quotations after 2021. The uncertainty and potential legal, economic, regulatory risk in discontinuation of the LIBOR has made financial regulators, authorities to actively move away from LIBOR and adopt Alternate Reference Rates (ARRs). The London Interbank Offered Rate (LIBOR) has been used extensively as a reference rate in a range of financial products and instruments for more than 40 years. 

RBI

Following such announcement, RBI has been closely monitoring the situation and in a recent Circular dated 8th July 2021 has issued issued an advisory to banks and other RBI-regulated entities emphasizing the need for preparedness for the transition away from London Interbank Offered Rate (LIBOR). The key steps to be taken in this regard include:

1. Banks and financial institutions are encouraged to cease entering into new financial contracts that reference LIBOR as a benchmark and instead use any widely accepted alternative reference rate (ARR), as soon as practicable and in any case by December 31, 2021.

2. Banks and financial institutions are urged to incorporate robust fallback clauses in all financial contracts that reference LIBOR and the maturity of which is after the announced cessation date of the LIBOR settings.

3. Banks and financial institutions are encouraged to ensure that new contracts entered into before December 31, 2021 that reference LIBOR and the maturity of which is after the date on which LIBOR ceases or becomes non-representative include fallback clauses.

4. Banks have also been advised to cease using the Mumbai Interbank Forward Outright Rate (MIFOR), a benchmark which references the LIBOR, as soon as practicable and in any event by December 31, 2021. In this context, Financial Benchmarks India Pvt Ltd (FBIL) has started publishing daily adjusted MIFOR rates from June 15, 2021 and modified MIFOR rates from June 30, 2021 which can be used for legacy contracts and fresh contracts respectively.

5. Contracts referencing LIBOR / MIFOR may generally be undertaken after December 31, 2021 only for the purpose of managing risks arising out of LIBOR / MIFOR referenced contracts undertaken on or before December 31, 2021.

Reserve Bank will continue to monitor the evolving global and domestic situation with regard to the transition away from LIBOR and proactively take steps, as necessary, to mitigate associated risks in order to ensure a smooth transition.

Background

The Financial Conduct Authority (FCA), UK, in a press statement dated March 05, 2021 announced that all LIBOR settings will either cease to be provided by any administrator or no longer be representative:

• Immediately after December 31, 2021, in the case of all Pound sterling, Euro, Swiss franc and Japanese yen settings, and the 1-week and 2-month US dollar settings; and

• Immediately after June 30, 2023, in the case of the remaining US dollar settings.

The transition away from LIBOR and the adoption of ARRs developed in various jurisdictions is a significant event which needs to be carefully prepared for in order to manage potential customer protection, reputational and litigation risks as well as avoid disruptions to the safety and resilience of financial institutions and overall financial stability of the economy. In August 2020, the Reserve Bank had advised banks and financial institutions to assess their LIBOR exposures which will mature after the cessation of the LIBOR as also frame a Board-approved plan for the steps to be taken to address the risks arising from the LIBOR transition.

What is LIBOR? Forbes - Libor

LIBOR provides loan issuers with a benchmark for the interest rates they charge on different financial products. Libor is set each day by collecting estimates from up to 18 global banks on the interest rates they would charge for different loan maturities, given their outlook on local economic conditions. These are averaged together to provide a range of Libor rates.

LIBOR is calculated in 5 currencies:

1. UK Pound Sterling

2. Swiss Franc

3. Euro

4. Japanese Yen and

5. U.S. Dollar.

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. Forbes

Why move away from LIBOR?

Partly due to various scandals germane to the 2008 financial crisis and changed market and economic conditions.

 Importance of "Fall-Back Clauses" - FHL Bank USA

One of the biggest questions financial institutions are grappling with is what happens to LIBOR-based cash products (adjustable-rate loans, floating-rate notes, etc.) when LIBOR is no longer available? Loan agreements for LIBOR-based products typically include a definition of LIBOR, and within that definition, certain “fallbacks” in case LIBOR cannot be determined based on the method provided in the agreement.

The fallbacks in legacy agreements for LIBOR-based cash products are generally designed to address what happens when LIBOR is unavailable on a temporary basis. While these fallbacks are practical for short-term unavailability of LIBOR, they are not viable as long-term solutions when LIBOR becomes permanently unavailable or no longer exists. Alternate rates are different from LIBOR and may materially alter the economics of the loan agreement, potentially creating “winners” and “losers” over the longer term. 

Financial Institutions across the globe are currently participating and collaborating to arrive at appropriate Fall-Back Clauses.

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