ISLAMABAD: The London Interbank Offer Rate (LIBOR) is dying a slow but predictable death as after serving as bedrock of the modern financial system for over 30 years, LIBOR is set to discontinue by the end of 2021.
The Bank of England estimates that this major interest rate benchmark underpins $300tn ($30tn in GBP markets) of financial contracts including, derivatives, bonds and loans.
These instruments cover practically every aspect of international financial system, including corporate loans, bonds, mortgages, student loans, asset-backed-securities and even commercial contracts.
With panel banks no longer compelled to contribute to the publication of LIBOR from the end of 2021, any existing contracts that reference LIBOR and mature after 2021, need to replace LIBOR with an Alternative Reference Rate (ARR). This is an important consideration for financial market participants in Pakistan.
“One of the key reasons that LIBOR discontinuance is a significant event is that the proposed alternative rates such SOFR for USD and SONIA for GBP, are fundamentally different from LIBOR,” said Haseeb Haque, managing partner for the financial services advisory firm, Fieldfisher Capital.
According to him, this creates economic exposure and operational complexities for market participants upon transition from LIBOR to an ARR.
Although all financial contracts, generally, contain fallback provisions that allow the use of an alternative benchmark in the case that LIBOR is not available, these provisions are suited for scenarios where there is a temporary disruption in the publication or availability of the benchmark.
“They do not cater for a situation where LIBOR ceases to exist permanently. Banks operating in Pakistan are exposed to LIBOR to a varying degree. Larger institutions may have significant direct and indirect exposure to LIBOR both at their local and international operations,” Haque said adding that the IPP sector is likely to be affected most in the corporate sector. Not only all their foreign currency loans are benchmarked to LIBOR, but the tariff model is also benchmarked to LIBOR for capacity payments.
“The stakeholders, including Nepra, will need to start reviewing these contracts and tariff models,” he continued.
From the regulators’ perspective, they obviously want to make sure that the financial institutions are prepared and ready to navigate this transition. They are also keen to ensure that financial market participants are not economically worse off because of this impending change. State Bank may also be considering reforming the local benchmark, i.e. KIBOR in line with international best practices. Some of the emerging markets such as Saudi Arabia, UAE and Turkey have already started looking at reforming their own local benchmarks.
However, different approaches to the selection of the ARR and re-pricing offer a trade-off between the objective of achieving economic neutrality and the ease of calculation and operational simplicity.
“LIBOR’s demise could play havoc with the smooth functioning of debt, trade finance and derivatives markets if ignored. Banks in other markets have been working on this for at least one year already and it will be interesting to see how financial institutions and other stakeholders in Pakistan manage the transition,” he concluded.
Copyright Business Recorder, 2021