By: Adam Schneider, Serge Gwynne, and Jennifer Tsim
The article first appeared in the BRINK News on August 14, 2019.
It has been almost two years since Andrew Bailey, CEO of the Financial Conduct Authority (FCA), announced that the FCA would not compel panel banks to submit to the London Interbank Offered Rate — or Libor — beyond 2021. While progress has been made for the transition since then, there is still much to do.
Known as the “world’s most important number,” Libor has more than $240 trillion linked to its daily fluctuations, according to Oliver Wyman estimates. It is tied to all sorts of financial products; you may have a mortgage or a student or auto loan tied to it, and your company probably borrows based on it. In other words, it drives your corporate interest expense.
Oliver Wyman’s new report on replacing Libor outlines why the speed of change needs to accelerate ahead of 2021 and lays out some actions for banks, regulators and market infrastructure to take.
The report argues that, while banks with large Libor-based exposures have used the time since the FCA’s announcement in 2017 to assess their exposure, develop transition plans and begin moving certain new transactions to risk free rates (RFRs), additional risks and complexities have emerged.
What Will Replace Libor?
Progress has been held back by uncertainties around where and whether term RFRs or alternative credit-sensitive benchmarks will be available. Smaller banks with less exposure appear to be planning to rely predominantly on the existing fallback clauses in contracts to bring about the transition away from Libor — an approach that regulators have explicitly advised against.
Activity now needs to shift from fallbacks to new product development and transition, and the speed of change needs to accelerate sharply to meet the 2021 deadline. This requires action by both market participants and regulators to avoid a major market disruption.
Actions To Accelerate The Libor Transition
Regulators: Regulators should remove disincentives for market participants to switch from Libor-based to RFR-based derivatives, including increased initial margin requirements for entering new RFR-based trades (particularly if existing trades were grandfathered), tax liabilities from realizing gains, and potentially adverse accounting effects.
They should also clarify whether or not credit-sensitive benchmarks are a realistic alternative to Libor and RFRs — banks would understandably prefer to use a credit-sensitive rate for lending. The hope that this will be possible is holding back development of products based on RFRs.
Banks: Banks should develop loan products based on RFRs. In the near-term, backward-looking RFRs are the only available option, and adjustments to interest observation periods may be required to mitigate systems and give advance visibility on cash flows. If and when term RFRs — or even credit-sensitive rates — are established, products using these rates could be added to allow customers (and banks) to choose. But banks cannot afford to wait due to the lead time to transition legacy contracts.
Preparations for transition of legacy transactions should also begin. Different impacts across different products within a single customer relationship will require integrated data and analytics and a consistent playbook for renegotiation, which will take time to develop due to the complexity of bank systems and organizations.
There are a series of new emerging risks that have not been sufficiently addressed and that will need to be urgently looked at.
Central counterparty clearing houses (CCPs): CCPs should accelerate the shift to secured overnight financing rate (SOFR) discounting and PAI (price alignment interest) on cleared derivatives to reduce dependency on Fed funds and increase demand for — and liquidity of — SOFR swaps.
Benchmark administrators: Benchmark administrators should accelerate development and publication of term RFRs, coordinating trading platforms and liquidity providers to secure access to the required derivatives or futures input data.
In addition, the risk of wasted effort and investment, particularly by banks in developing RFR-based loans, needs to be seen in the context of the bigger operational and financial risks of Libor being discontinued before the industry has transitioned.
The above actions will have to happen in parallel if the mammoth task of transitioning away from Libor is to be completed by the end of 2021. Further delays raise the risk of a market-wide dislocation, as well as economic, conduct and operational impacts for individual market participants.
New Risks Emerging
While there is uncertainty and progress has been slow, banks and industry groups are continuing to work to prepare for a transition from Libor. As these efforts progress, there are a series of new emerging risks that have not been sufficiently addressed and that will need to be urgently looked at.
Risk 1. Over-reliance on fallback clauses: Some market participants are planning to rely on updated fallback clauses to transition from Libor when it becomes unavailable. This creates major operational risk, from needing to process new and different fallback formulae, to needing to calculate new interest payments, valuations, margin and collateral requirements for tens or hundreds of thousands of contracts on a single day.
Risk 2. Inconsistency in fallback terms and triggers threatens risk management integrity: While current fallback language in contracts is inadequate because it may result in unintended consequences (e.g., floating rate notes fallback to the last Libor fixing and thus effectively become fixed-rate notes), it is at least reasonably consistent in terms of the fallback trigger (i.e., the non-publication of Libor) and the actual fallback rate itself within each asset class.
While new fallback language being developed by ISDA (the International Swaps and Derivatives Association) and other industry bodies is a positive step forward, differences in fallback language for subsets of transactions could result in increased basis risk.
Risk 3. Conduct risk and data complexity in the repapering process: Negotiations to “repaper” existing transactions will be challenging. Banks require a complete view of their exposures to each customer/counterparty and the estimated economic impact of transition across products and currencies, including the differences in fallback terms. This is particularly challenging when products are booked across different businesses and will require significant lead time.
To mitigate the conduct risks of transition, banks will need to develop standardized treatments, decision trees and playbooks with appropriate governance to ensure a defensible position when selecting replacement rates. A fragmented approach could negatively impact customer relationships and lead to reputational damage, economic loss, conduct fines or legal action.
Risk 4. Impact on earnings from using a risk-free rate for lending: With so many variables still unknown, most banks have not yet begun to formally and quantitatively analyze the economic, balance sheet, and P&L impact of various transition scenarios, nor the potential impact of future stress scenarios once the industry has transitioned to RFR-based products.