Call it a friendly nudge.
Regulators in the UK have told banks, insurers and other financial firms to send by Dec. 14 details on their firms’ plans to move away from the London interbank offered rate, among the world’s most recognized financial statistics.
The UK’s Prudential Regulation Authority and Financial Conduct Authority sent joint letters to the chief executives of large financial-services firms asking for a summary of their assessments of the risks of moving away from the rate, known as LIBOR, by the end of 2021 as scheduled, as well as the specific steps they would take to reduce those risks.
The regulators also asked the CEOs to identify one or more senior managers who will oversee the transition at their firms to the alternative interest rate.
Often described as the world’s most important number, LIBOR serves as the benchmark interest rate for everything from complex derivatives products and fixed-income trades to adjustable-rate mortgages. In all, roughly $240 trillion of loans and other instruments around the world are tied to the LIBOR rate, according to Oliver Wyman estimates.
Yet regulators in the UK for the past four years have pushed for the elimination of LIBOR as a benchmark. The rate has been subject to manipulation over the years, and the methodology for calculating it is often based on only a handful of real world transitions. Despite recent efforts to improve the rate, the market underlying the rate is too limited to avoid subjectivity in its calculation, prompting regulators to seek a replacement.
Some financial firms, however, have been reluctant to imagine a world without LIBOR. Lenders have become accustomed to LIBOR as a benchmark and have embedded it everywhere in their organizations. They worry about the uncertainty of scrapping it.
The transition from LIBOR is expected to bring considerable costs – and risks – as firms are forced to update risk models, valuation tools, product design and hedging strategies.
The main problem: after LIBOR is gone, there will still be lots of products on the books of banks and insurance companies that depend on it. Contracts often include fallback provisions specifying contract terms in case LIBOR is unavailable. If the period of unavailability is brief, say due to a technical glitch, as was expected when the contracts were drafted, the resulting losses and gains will be manageable. But if fallback terms are used for the remaining life of the contract, the economic impact is likely to be significant, creating winners and losers.
“Under every LIBOR rock there is another rock,” said Serge Gwynne, Partner at Oliver Wyman. “LIBOR is pervasive, and the regulators want to know that the banks really understand the risks.”
The UK regulators rolled out a new risk free rate called SONIA based on actual transactions between financial-services firms, rather than assumptions made by firms about what it would cost for them to borrow. For its part, the US Federal Reserve in April launched a rate to replace dollar LIBOR known as the Secured Overnight Funding Rate, or SOFR.
No one is forcing the banks to use these rates, but they are picking up momentum, and when LIBOR goes away they will likely be the best option. Yet neither of them will mirror LIBOR, hence the concern for the industry -- and now clearly the regulators -- about who will carry the cost.
The UK regulators have asked the question but US CEOs should expect the same. This will be a fire drill unless they are ready.Adam Schneider, Partner, Oliver Wyman
“The UK regulators have asked the question but US CEOs should expect the same,” said Adam Schneider, Partner at Oliver Wyman. “This will be a fire drill unless they are ready.”
The letters are expected to be the start of numerous requests from the FCA, PRA and other regulators as 2021 draws near and transition plans are cemented.
The CEO letters also should be helpful for people working on LIBOR transition within banks to get the attention of senior management and budget priority. The LIBOR deadline – the end of 2021 – seems far off compared with nearer-term challenges such as Brexit, but the letters addressed directly to individual CEOs should add a sense of urgency.
So how should financial firms cope? Besides announcing a transition lead, firms will have to spell out a risk framework that accounts for the wide scope of potential negative consequences from the transition, from economic and legal to reputational risks as agreements are updated. Firms that are continuing to sell products based on LIBOR face real conduct risk, but there are often no viable alternatives because the replacement rates are not mature yet.
Firms also will need to develop scenario-based plans and spell out actions to be taken under each of them. And they need to start engaging with their boards. The transition can’t be a middle-management exercise; it will need to closely involve senior management and the board that oversees them.
“It’s time firms speed through the five stages of LIBOR grief and into acceptance,” said Paul Cantwell, Partner at Oliver Wyman. “The urgency to mobilize is only increasing.”