A few weeks back, I attended a financial sector specialist meet at New York. Apart from rapid technology transformation issues, a major discussion took place about transitioning from LIBOR to a new order, popularly termed as IBOR or Inter-bank Offered Rate, to shift the power from traders to finance or independent units for rate fixation.

The London Interbank Offered Rate (LIBOR) is a global benchmark interest rate that is prepared across major currencies and markets. It is computed and published daily by the Intercontinental Exchange (ICE). Top tier multinational banks use the rate to provide short-term loans to one another in the international interbank market.

However, use of LIBOR is coming to an end in 2021. The financial crisis caused a notable reduction in transaction volumes in the unsecured inter-bank lending market. Therefore, LIBOR computation has been primarily based on expert judgement due to insufficient transaction data. Regulators as well as panel banks have expressed concerns which further grew with the 2012 LIBOR scandal. Banks were caught manipulating the rate to enhance their profitability. As a result, the Financial Stability Board (FSB) decided to devise a different method of rate calculation and transition by 2021.

This transition is expected to have a massive global impact and on Bangladesh as well, whatever may be the market’s exposure is likely to be somehow affected. The change is going to be significant and will require immediate attention from financial institutions. However, preliminary reports reflect that a majority of banks and other financial institutions in Bangladesh are oblivious to the change and no notable step to make the transition has been taken yet.

Studies report that this wait-and-see approach is risky given the volume of products and processes which require alteration. Bangladesh, though in the short term has lending contracts of $7.5 billion outstanding in recent times, backed by either intra-company borrowing or borrowing from Middle Eastern or European banks.

The Dhaka Interbank Offered Rate (DIBOR), though not very active, is administered by the Bangladesh Foreign Exchange Dealers’ Association (BAFEDA) and was introduced in 2010. The rate is computed using the same methodology as LIBOR, meaning it is also likely to be open to manipulation. Therefore, with the above-mentioned issues with LIBOR, it is strongly recommended to utilize a more compatible risk-free rate for financial operations.

A PwC publication predicts that the transition away from LIBOR can either be a slow rolling disaster or a once-in-a-generation opportunity. LIBOR is currently rooted into US$350 trillion dollars’ worth of financial contracts globally. This must now be re-contracted or closed. The change may cause delays and disruptions to company operations and cost of capital will be altered significantly. This is because alternative rates will affect contract prices and change the risk management systems of an entity.

The evolution will alter a firms’ market risk profiles, demand modification to risk models, valuation tools, product design and hedging strategies. There is also a question of how to maintain contractual continuity as various agreements which reference LIBOR have not anticipated the permanent cessation of the benchmark. Industrial bodies such as the International Capital Markets Association (ICMA), the International Swaps and Derivatives Association (ISDA) and the Alternative Reference Rate Committee (ARRC) are working towards developing a fall-back language catering to affected contracts.

Moreover, financial reporting and tax issues would arise as recognition, de-recognition and measurement of assets and liabilities would need to be reformed. The International Accounting Standards Board (IASB) recently issued an exposure draft called ‘Interest Rate Benchmark Reform’ which recommended alterations to IFRS 9 and IAS 39.

To substitute LIBOR, five alternative rates are currently being devised which differ by region, tenor, currency and basis. This includes the Secured Overnight Financing Rate (SOFR), Tokyo Overnight Average Rate (TONA), Euro Short-Term Rate (ESTR), Sterling Overnight Index Average (SONIA) and the Swiss Average Rate Overnight (SARON).

Most of the above-mentioned substitutes are ‘backwards-looking’ overnight rates. They are founded on actual historic transactions and issued at the end of the overnight borrowing period.

Even though the end of 2021 seems far off, mitigating the risks and adjustment will surely take most firms a large amount of time. Uncertainty is likely to linger and there may be significant consequences if progress is further delayed.

Sketching out a clear roadmap and expected risk identification to transition is essential for all firms at this stage. Therefore, with a smooth transition to nearly risk-free rates, firms are likely to have priced contracts moving forward.

While there should not be large panic about the aforementioned transition, as most global banks are prepared, we in Bangladesh or local banks need to take cognizance of this, especially where there is a need to rewrite contracts and underlying documentation.