Benchmark reform is high on the agenda for financial institutions, and the upcoming transition from interbank offered rates (IBORs) to alternative reference rates (ARRs) tops the list.
There’s a growing sense of urgency among financial services firms to act after the announcement by the UK’s Financial Conduct Authority (FCA) that companies need to end their reliance on the London Inter-bank Offered Rate (LIBOR) by end of 2021.
That doesn’t leave banks with much time to implement a program of this scale – especially when you consider that an IBOR Global Benchmark Transition Report published last year found that the level of preparedness among those surveyed was still at an early stage.
Recognizing the scale of the challenge and the lack of preparation last September, the Prudential Regulation Authority (PRA) and the FCA released a “Dear CEO” letter to major banks and insurance companies in the UK, requesting information about their IBOR transition readiness. Responses were to be submitted before the end of 2018. Initial feedback from the regulators suggests that firms are at different stages of readiness with some holding their first IBOR transition leadership meeting after receiving the letter.
This request has given firms a strong impetus to focus on the IBOR transition and encourages both client and counterparty awareness. It has also become a blueprint for expectations for firms to demonstrate their IBOR transition readiness in jurisdictions across the globe. For instance, the Swiss Financial Market Supervisory Authority (FINMA) has sent a similar letter to supervised entities, with responses due by 30 April this year.
The challenges associated with transitioning from IBORs to ARRs cannot be underestimated. IBORs have been in use for more than 40 years, but their systemic footprint across the financial system is not widely appreciated. Most global firms would struggle to measure their exposure to IBORs across different rates, tenors and currencies at an enterprise level. As they plan for the transition and mobilize a program to manage the process, firms need to first understand the impact this change will have on their products, systems, processes, legal contracts and models.
Here are five ways that firms can prepare for the IBOR transition:
Given the complexity of the transition from IBORs to ARRs, all firms should be proactive in managing the potentially significant risks. It will be important to appoint a transition team and a senior IBOR program executive who’s responsible for assessing, planning and coordinating a multi-year, enterprise-wide program.
Many issues need to be considered in the move from IBORs to nearly risk-free ARRs. For a start, the volume of IBOR-denominated products is not decreasing as new transactions referencing IBOR continue to be written every day. Therefore, a key part of the transition must be the ability to offer products that reference the new ARRs instead of IBOR.
Besides prioritizing the transition of the front book, firms also need a strategy to manage legacy contracts. They need to perform a comprehensive impact assessment across legal contracts, system, processes and models to understand and plan for a discontinuation of IBORs. This is essential to ensuring that legacy contracts that reference IBORs and mature after 2021 can continue to be serviced.
This assessment should include whether the fallback language is strong enough to survive a post-LIBOR world. Consistency of fallback language between derivatives and cash products is another critical consideration to ensure that hedges continue to perform in the manner intended. Consideration must also be given to whether updating fall back language alone is sufficient since it is designed to be a “seat belt” in a contingency and not a business as usual documentation.
IBOR will impact nearly every product, business and enterprise function within a firm. Implementing a transition program will need to cut across every global business line. This includes global markets, global banking, retail banking, insurance and asset servicing, as well as risk, finance, legal, data, systems and processes. A bank with a global footprint also must deal with different currencies – and products – transitioning at different times.
There is a temptation to see this as a regulatory-driven change. However, the IBOR transition is going to change how derivatives, loans, cash and retail products are priced, risk-managed and valued. Banks need to articulate and implement a business strategy and roadmap for transition based on assumptions around the speed of the roll-out of new products, market liquidity and industry working group developments. This is key to ensuring that banks maintain their competitive position and market share as new products emerge.
The transition also means that banks will have to operate in a dual-rate environment for an extended period. This will have an impact on the operating model for banks. In particular, FTP, Asset Liability Management and risk and valuation models are significantly impacted in a dual rate environment and will merit focused attention.
So, there’s much for firms to ponder – and act on – if they’re to ensure their transition to ARRs is a smooth one.
This article was initially published on EY.com based on the work of: