April 9, 2019
One of the biggest issues in the risk and regulatory space is about to cause major concern for regulatory bodies, financial institutions, and Ankura clients around the world. The London Interbank Offered Rate (LIBOR) — the reference rate for more than $300 trillion of financial contracts ranging from derivatives and swaps, commercial mortgage-backed securities (CMBS) and residential mortgage-backed securities (RMBS), to commercial and residential mortgages — is being phased out.
LIBOR, once dubbed the world’s most important number, has been rocked by manipulation scandals and will be replaced by year-end 2021. What will supersede this benchmark is not yet known, but the uncertainty is set to cause ripples across the globe.
Regulators around the world, including the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, and its global counterparts, have begun the hunt for a replacement benchmark, and it’s likely that there will be several replacement benchmarks declared around the world. How these are established and interact with each other will remain to be seen and will be a separate topic of discussion.
The transition away from LIBOR will be one of the largest transformations that firms will have to undertake in living memory, so delaying preparations is simply not an option. Firms should begin to assess their vulnerabilities and exposure, and carefully plan their strategy to navigate the changes. Firms that start the process early will have a smoother, less costly transition.
Regulators are already asking banks about LIBOR transition readiness and progress, and the level of their scrutiny will only increase as time ticks on. At this point in time, banks should be able to provide their regulators with their LIBOR exposure and be able formulate their transition strategy.
Firms should begin by performing a readiness assessment, which includes a LIBOR inventory, exposure quantification, and transition and mitigation strategy. Ankura’s financial services professionals can assist with this readiness assessment.
This transition will place an immense burden on many institutions and is likely to consume operations and legal teams for the upcoming years. New contract terms will need to be negotiated, documents will need updating, and financial models will need to be revised and fully redeveloped, as most older contracts only include fallback language addressing the short-term absence of the benchmark rate, not the discontinuation of the rate. To get a head start, treasury professionals may want to stay as flexible as possible in their fallback language. Further, banks should renegotiate existing contracts to add broad language that gives the bank discretion in selecting an alternative or fallback rate in the event the LIBOR benchmark is substantively discontinued. This effectively adds a placeholder saying that both parties will agree to make changes once the replacement is determined.
With such complications, many firms are reaching out to secure access to experts to assist in assessing their LIBOR exposure, and to develop and begin to execute on their transition plan.
There are many risks associated with under-preparedness. We see execution, basis, reputation, and litigation risks as chief risk factors related to the benchmark transition.
What will replace LIBOR?
In the US, the Secured Overnight Funding Rate (SOFR) is emerging as the likely successor to LIBOR. SOFR is published by the Federal Reserve of New York each business day and, in summary, is the cost of overnight cash borrowings collateralized by Treasury securities. The SOFR is currently based on secured contracts, while LIBOR is based on overnight unsecured contracts. This means that basis risk will be introduced, as merely substituting SOFR for LIBOR in products or contracts would radically alter expected cash flows and behavior as interest rates change.
Outside the US there are likely to be several different successors. For example, in the UK, the Sterling Overnight Index Average (SONIA), a widely used interest rate benchmark, will likely prevail as a LIBOR replacement. In Japan, the Tokyo Overnight Average Rate (TONAR), was proposed and adopted as Japan’s answer to the LIBOR issue. With such an alphabet soup of rate, divergent methodologies, volatility, and ultimately rate inequality differentials will cause both market confusion and discord, to further complicate transition.
The LIBOR transition requires products to be analyzed to determine which rate should be used. As an example, the SOFR may be published for longer durations which may be more applicable for certain products; or a firm may decide that another published benchmark is most appropriate for other products. Further, financial firms will need to determine if, and/or what adjustment to the existing add-on (for example Rate +200) is required to maintain the same economics of the transaction.
The chart below plots the rate differential between the one- and three-month LIBOR rates against the overnight SOFR, evidencing the need for either a longer term SOFR rate or changes to the margin to keep the economics of the transaction neutral.
Source: Federal Reserve Economic Data (FRED), Federal Reserve Bank of St. Louis, and Ankura analytics
Retail customers will also be impacted
Given many adjustable rate mortgage and consumer loan rates are linked to LIBOR, retail customers will be impacted, bringing further exposure to reputational and litigation risk to lenders and other consumer-facing financial bodies.
Retail customers, especially those who do not understand their loan’s rate determining process, may believe they are being treated unfairly once they learn that their mortgage rate is changing to SOFR +280 from LIBOR +250, for instance. On the perception alone, the increase may convince customers that they are being harmed and may think they have nothing to lose by refusing to agree to mortgage contract amendments, thereby threatening timely execution. Furthermore, banks will experience additional regulatory pressure to provide transparency evidencing the consumer is not being negatively impacted.
Consumers may look to organize or seek compensation for their consent. Early, clear, and direct communication with retail customers will play a key role in reducing reputation and litigation risks.
The Ankura approach
Ankura transaction advisory services (TAS) and risk and advisory services (RAS) professionals encourages its clients to begin the process now to understand their exposure to the benchmark and enact a transformation strategy. For many institutions, the transition will be a large labor-intensive task that opens new key new risks. As part of a prudent risk management strategy, financial institutions will want to identify, quantify, and reduce their risks quickly. Given the size, scale, and risks associated with this exercise and the reach of LIBOR across most institutions, there is no time to delay. Complacency is not an option.
Early action will begin to pave a smooth transition process, allowing management and boards of directors the time to address the significant risks outlined above.
Ankura’s TAS and RAS professionals have a long-standing track record of creating innovative solutions to assist financial services clients in managing complex transitions, such as CECL and LIBOR, resolving critical and complicated risk and regulatory-related matters, and optimizing the balance sheets and financial performance of their clients.
We offer our clients a wide range of services, spanning from full-service project planning and execution to providing subject matter experts and consulting services for specific functions, such as model development and validation, readiness assessments, strategic planning, and various risk and regulatory topics.
Ankura’s experts are highly qualified, with industry-leading experience in banking, transformation, modeling, risk, credit ratings, strategy, banking products, valuation, and operational due diligence.