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Is your bank ready for the LIBOR transition?

Our recent industry survey suggests that many are not. Here are the questions bank leaders need to ask as they seek to catch up.

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International financial markets are leaving LIBOR (and related benchmark rates) in the rearview mirror, and switching quickly to alternatives such as the Secured Overnight Financing Rate (SOFR) in the United States. Monthly SOFR issuance increased from $2 billion in September 2018 to $50 billion in August 2019, with weekly swap-trading volume tripling from less than $5 billion in January 2019 to $14 billion in September 2019. In the United States, the Federal Reserve, the Securities and Exchange Commission, and the Commodity Futures Trading Commission have each promoted the transition, by granting regulatory relief, publishing transition guidance, and emphasizing the criticality of a timely transition. European and other international regulators have urged a comparable playbook on bank boards, management teams, and other key stakeholders.

The change has happened much faster than many expected. In our view, many banks are at risk of falling behind on the most significant and complex change in the financial industry since the introduction of the euro. With a little more than two years remaining before December 31, 2021 (the last date upon which LIBOR panel banks will be compelled to make LIBOR submissions), the scale of the transition is rapidly dawning on industry participants. The volume of effort required to adapt contracts, models, and systems should not be underestimated, especially with other contemporaneous large programs (such as those addressing Brexit and Initial Margin) already taxing banks’ resources. We estimate that 50 to 75 percent of banks’ models involve LIBOR and will need to be redeveloped, and almost all systems will require some remediation. Additionally, at several banks, more than 80 document types will need to be reviewed for potential “repapering.”

Critical milestones are rapidly approaching. First up are changes from the International Swaps and Derivatives Association (ISDA), which will publish new, more robust, fallback language for many LIBOR-related derivatives contracts (both legacy and new exposures), stipulating the terms and the rates that will prevail in a post-LIBOR world. The final form of the ISDA conventions is also likely to serve as a bellwether for the cash market.

More LIBOR-related changes are on the way, including the Q1 2020 Comprehensive Capital Analysis and Review (CCAR) submission to the Fed (which will include, for the first time, a period following the expected phase-out of LIBOR), and clearing house adoption of SOFR to calculate interest on collateral and discount cash flows in H2 2020 Each of these events will have significant and complex implications for banks.

Recent turmoil has also injected a note of urgency into banks’ preparations. The spike in repo market rates has translated into SOFR volatility (as expected; SOFR is derived from repo markets), with SOFR doubling to 5.25 percent on September 17 from 2.43 percent the day prior. Efforts by the Fed to stabilize markets have dampened volatility. And in the long term, sizable moves are less likely in SOFR (which is averaged over a longer time period when used in financial contracts) than was true of LIBOR (which was, of course, famously subjective). But the episode has caught the eye of bankers everywhere.

Nonetheless, many banks are still struggling to gain traction on the transition. We recently surveyed several large and regional banks globally. While all have begun to inventory their financial and nonfinancial exposures, most have not yet comprehensively translated that information into quantified risks, with specific metrics, under different scenarios. In addition, most banks have not developed detailed plans to remediate their contracts, systems, and models over the next 2.25 years. Nor have they considered the overlap of work with other parallel programs. Finally, we have seen only a handful address specific client needs based on clients’ knowledge of the rate changes and the complexity of their unique LIBOR exposures.

Addressing these challenges is only a part of what banks must do. We see six sets of critical questions that LIBOR transition leaders should address: 

  • Top team and board awareness. Are the CEO and management team receiving regular and effective updates on risk exposures and transition readiness? Does the top team know about any operational issues? Are key committees (for example, asset-liability committee, risk, and the board) regularly apprised of progress, and included in strategic decisions?
  • Exposure reporting. Can we quantify our LIBOR exposures, both financial and operational, across all systems, models, and contracts? Can we do it again, if needed? Is our exposure to LIBOR growing or falling?
  • Transition plans. Do we have a month-by-month transition plan, with accountable owners appointed for every action? Has this plan been checked for overlaps with other large programs?
  • Resourcing. How complete is our budget for the LIBOR transition? Does it cover all critical areas, including repapering, model redevelopment and validation, and systems remediation?
  • Risk assessment. Have we identified and prioritized key transition risks and defined possible mitigants? Which areas are we most concerned about?
  • Opportunity identification. Banks can gain an advantage by being first to market with new financing and treasury products tied to the new reference rates, as well as tools to manage the new risks. Have we identified the primary opportunities arising from the transition?