(L)IBOR Transition Pulse Check for 2021: What Your Bank Needs to Know

By 31 December 2021, the London Interbank Offered Rate (LIBOR) settings for all British Pound (GBP), Euro (EUR), Swiss Franc (CHF) and Japanese Yen (JPY), as well as one-week and two-month US Dollar (USD), are expected to cease. Banks will also discontinue the issuing of new USD LIBOR contracts.

As we approach the first LIBOR transition milestone at the end of December 2021, regulators around the world have increased efforts to ensure banks are ready to meet the deadline. Efforts include increasing the banks’ frequency of existing LIBOR exposure submission, and enquiries on the banks’ level of readiness to meet the LIBOR transition deadline.

From a corporate governance perspective, setting a clear and firm tone from the top for all banking functions to adopt an “Alternative Reference Rate (ARR)-first” approach when transacting with clients going forward is crucial in ironing out the steep transition curve for USD LIBOR and Swap Offer Rate (SOR)1. Effective customer communication plans are also expected to be set up to ensure fair treatment of customers when dealing with LIBOR-linked contracts2.

While it has been more than four years since the LIBOR cessation was first announced by the Governor of the Bank of England, Andrew Bailey, on 27 July 2017, many corporate banking clients have provided feedback that they still do not understand the ARR-linked products and options that are available in the market. They expect their respective banks to provide clearer guidance on the treatment of their existing LIBOR exposure.

Without the proper controls and frameworks in place, potential economic consequences include less favourable fallback rate compared to LIBOR rate, basis risk due to a mismatch between the fallback rate of loan and hedging of loan interest rate, and in the worst-case scenario, default risk as a result of an incorrect reference to LIBOR.

What are the key risks?

The LIBOR transition is a large-scale transformation that involves many banking functions and brings about various risks that need to be addressed simultaneously.

The risks involved in LIBOR transition is summarised in Figure 1. For the purpose of this article, we will deep-dive into the following risks:

  • Valuation and market risks
  • Operational and IT risks
  • Conduct risks
(L)IBOR Transition Pulse Check for 2021: What Your Bank Needs to Know 2
Figure 1 Impact assessment of key risks across the bank

Key challenges which banks may face

#1: Evolving market and valuation risk to implement ARR
Market risk

With ARR only introduced recently to replace the LIBOR rates, there are insufficient observable historical data points for it to be considered as a modellable risk factor under the Risk Factor Eligibility Test (RFET). Banks will need to recalibrate their calculation model for expected shortfall and value-at-risk under the Fundamental Review Trading Book Internal Model Approach (FRTB IMA).

As LIBOR phases out, the number of real observable prices will decline, leading the benchmark interest rate to become a non-modellable risk factor (NMRF), just like ARR. This implies that banks might need to buffer additional stress capital add-on for both ARR and LIBOR Fallback to fulfill the Basel Committee on Banking Supervision (BCBS) requirements.

Synpulse’s recommendations:

  • Amalgamate existing specialised silo teams working on LIBOR transition and FRTB reform to ensure that reference rate changes are properly communicated and assessed for incremental market risk and capital requirements.
  • Conduct an impact assessment on current risk management systems to ensure that stressed expected shortfall, value-at-risk, and other risk factors are calibrated accurately to reflect the bank’s risk capacity.
Valuation risk

The difference in attributes between existing LIBOR and new ARRs gives rise to the need to adapt existing valuation methodology, market data management, and independent price verification (IPV) processes to accommodate ARRs. As ARR are overnight risk-free rates that carry little to no credit default risk, this means that the credit and term spread would need to be configured in the new ARR time series curves to preserve the economic value of the contract.

Synpulse’s recommendations:

  • Banks should configure their term structure models and pricing engines to manage the economic differences between LIBOR and ARR, and minimise P/L fluctuations.
  • Banks should perform an impact assessment to determine how their funds transfer pricing (FTP) curves should be constructed to measure pricing and profitability accurately in post-LIBOR times.
  • Conduct front-to-back system validations to ensure that trade flow and downstream system capture aren’t disrupted by new external data feed, internal valuation models, and risk management system configurations.
#2: Impacts on systems and products

Various pre-emptive countermeasures have surfaced, such as fixing lag and observation shift, to give sufficient notice on the interest payment under the “in arrears” arrangement for ARRs to both borrowers and lenders. While the fixing date under LIBOR is typically two business days before the interest payment date, the lookback period under ARR can range from two to five business days if an observation shift period is applied. These changes imply that various technology systems will need to be enhanced to accommodate the new features.

For instance, additional fields for new ARR indexes, lookback and observation shift periods, and revised day count fraction conventions would have to be incorporated into the front-office trade capture systems to accurately reflect the economic terms of the restructured contracts. For front-office systems that are not operationally robust to support the new ARR features, banks might turn to approximate bookings and expect manual workarounds for downstream risk management and finance reporting stakeholders to model and represent the bank’s risk exposure appropriately.

Separately, banks would need to configure the time series curves and connectivity to external data feeds in valuation models. This ensures that trades don’t fail to gain value after switching from the term structure-based LIBOR to ARR rates. System enhancements in the service letter agreements (SLA) between third-party vendors should also be finalised to meet the end-2021 timeline.

Most banks will now also need to submit their existing LIBOR exposure of all impacted products (e.g., loans and derivatives) on a monthly basis, instead of the previous quarterly basis, to their respective regulators. Submission reports include the bank’s progress in the LIBOR transition program and a summary of its remediation strategy for its LIBOR transition project (i.e., is the bank ready to issue ARR-linked products?). Furthermore, some regulators have started asking what the banks deem as “adequate” fallback language.

Synpulse’s recommendations:

  • Amalgamate existing specialised silo teams working on LIBOR transition and FRTB reform to ensure that reference rate changes are properly communicated and assessed for incremental market risk and capital requirements.
  • Beyond systems and products, detailed impact analysis should be conducted across key areas and monitored closely on a regular basis (Figure 2).
  • Take inventory of all the bank’s existing LIBOR exposure, especially for contracts that require immediate remediation (e.g., mature before the cessation date of the respective rate, flagged by legal as existing fallback provisions are not robust). A progress report may prove beneficial to illustrate the bank’s development on impacted LIBOR-linked products and identify key areas which require additional support.
(L)IBOR Transition Pulse Check for 2021: What Your Bank Needs to Know 3
Figure 2 Potential key areas of change across the bank due to LIBOR transition
#3: Addressing potential conduct risk arising from LIBOR transition

Regulators such as the Hong Kong Monetary Authority (HKMA) have placed strong emphasis on the fair treatment of customers and require financial institutions (FIs) to uphold its customer protection principles when negotiating to remediate existing LIBOR-related contracts.

Potential risks may include:

  • Lack of transparency in communicating risk and rewards of LIBOR or ARR-linked products when making investment recommendations to customers
  • Failure to seek management approval based on the approval matrix prior to transacting in LIBOR-linked products post-internal cessation deadlines
  • Failure to identify existing contracts which lack robustness in fallback language

Furthermore, transitioning existing contracts that reference LIBOR to ARR might potentially create risk for clients. An example is when clients are transferred to unfair rates or inferior contractual terms, leading to value-transfer risk. Such products may be unsuitable if they do not perform as expected under the new reference rates due to low levels of liquidity in the market.

Synpulse’s recommendations:

  • Conduct a self-evaluation of their existing frameworks, policies, and controls to ensure that they are adequate to address any potential risk. It’s the bank’s responsibility to identify any potential risks (Figure 3) that aren’t in the customer’s best interest and assess whether mitigation actions have already been in place.
  • Keep a repository of frequently asked questions by customers regarding the LIBOR transition and address them according to the banks’ current position. Relationship managers (RMs) can leverage this by providing a consistent response to the customers when addressing LIBOR-related questions. This also establishes the customers’ trust when the RMs demonstrate the bank’s ability to respond to their queries effectively.
(L)IBOR Transition Pulse Check for 2021: What Your Bank Needs to Know 4
Figure 3 Examples of conduct risk categories

Moving forward with Synpulse

Synpulse has worked together with multiple partners across Asia-Pacific and Europe on the LIBOR transition such as process impact analysis through our BANKINABOX® reference model, conduct risk assessment, and project management support. Whether you’re an FI or a solution provider, we believe in adding value through both our banking process knowledge and IBOR transition expertise.

Reach out to us to find out how we can support your (L)IBOR transition journey.

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