Libor Risk Q&A – KPMG

Chris Dias and Chris Long, principals and global Libor solution co-leads, discuss key industry concerns around the transition away from Libor, including how the discontinuation deadline will be impacted by the Covid‑19 pandemic, the benefits and challenges of pre-cessation triggers, and how firms are preparing for ‘big bang’ discounting switches

Considering the impact of the Covid‑19 pandemic, how realistic is the end‑2021 deadline for Libor’s discontinuation? 

Chris Dias, KPMG

Chris Dias, KPMG: Covid‑19 is having a noticeable impact on the timing and release of financial regulation. Regulatory agencies worldwide have postponed a number of rules and regulations, recognising the added burden Covid‑19 has placed on institutions. The relief has been carefully measured, balancing the support of markets and the overall economy while continuing to maintain regulatory responsibilities. For example, the Basel Committee on Banking Supervision deferred the implementation of Basel III capital rules by a year, the European Securities and Markets Authority delayed phase one of the Securities Financing Transactions Regulation, and the US federal banking agencies – the Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency – issued a joint statement allowing banking organisations to mitigate the effects of the credit loss standard in their regulatory capital for up to two years.

The same cannot be said for the Libor transition. Global regulators and risk-free rate (RFR) working groups have made it clear that the cessation of Libor by the end of 2021 is a global imperative. Although seemingly resolute on the Libor end-date, regulators do seem willing to make some accommodation because of Covid‑19. To that end, certain milestone dates may be deferred. A case in point is the recent Sterling Working Group announcement to delay the stoppage of all new sterling Libor-linked loans to the end of the first quarter of 2021 due to pressures caused by Covid‑19. In a related example of regulatory willingness to modify efforts to wean market participants off of the ‘Libor drug’, the Fed changed its Main Street Lending Program requirements from the secured overnight financing rate (SOFR) to Libor to ensure access to much-needed 

financial relief. It appears regulators will bend when rewired to help mitigate risks from Covid‑19. It also appears the Libor transition will continue along a defined path with only minor detours along the way.

 

The UK Financial Conduct Authority (FCA) has extended the deadline for participants to cease issuance of cash products linked to Libor to the end of the first quarter of 2021 – what additional preparation is needed to ensure Libor cash products are no longer issued?

Chris Long, KPMG

Chris Long, KPMG: The FCA’s extension giving participants more time to stop issuing Libor cash products was a response to Covid‑19. Whatever the rationale for the extension, it came as welcome relief to a number of institutions that may have been ill-prepared to meet the Q3 2020 deadline. While efforts to cease the issuance of Libor cash products should have been well under way, the extension does provide an opportunity to revisit and possibly reformulate plans to fully transition from Libor to the sterling overnight index average. Firms should look at existing plans to ensure strategy, technology, customer outreach, operations, business process and communications have all been adjusted to reflect the upcoming change. Additionally, should customers continue to require Libor-linked loans, the respite granted should be used to ensure fallback language is appropriate. 

 

Considering the discrepancies between the two benchmarks in March, what can we learn about the suitability of SOFR as a viable fallback for US dollar Libor contracts? 

Chris Dias: Regulators and the Alternative Reference Rates Committee have made it clear that differences exist between SOFR and Libor. These differences are both structural and behavioural, leading to outcomes that may not align with certain expectations while also bringing about challenges to suitability. There is no doubt that these differences will impact both revenue and profitability, requiring institutions to rethink balance sheet management, credit risk management, interest rate risk and pricing strategies. While, on the surface, the choice of SOFR may not appear a suitable alternative to Libor, it can be made to be a more robust alternative by recognising the differences and making the necessary adjustments.

 

What role will alternative, credit-sensitive benchmarks, such as Ameribor and the Ice Bank Yield Index, play in transition, and will multiple versions prevail?  

Chris Dias: The emergence of credit-sensitive rates indicates the need by some market participants for a rate closer in construct to the current Libor. While these credit-sensitive rates offer some similarities, they either are not identical to Libor or have similar issues that made Libor problematic. The need for credit-sensitive benchmarks is predicated on the fact that funding and lending costs generally either widen or remain static in times of stress. The current perception is that, without the credit-sensitive component, banks could experience negative impacts to revenue and profitability from the narrowing between funding and lending, certainly an unwelcome outcome for banks but perhaps not for the real economy. Support for SOFR alternatives would need to address the operational inefficiencies, structural differences between a rate and Libor, and potential accounting problems – currently this is not the case. Additionally – for any UK or European Union‑based financial institutions – any credit-sensitive benchmark would need to be compliant with the EU Benchmark Regulation before it can be used. Alternatively, banks could make adjustments to pricing strategies, increase fee-based lending or employ a more dynamic risk-based approach; in any case, market fragmentation is not the answer. 

 

Industry opinion appears to be moving in favour of pre‑cessation triggers – what are the challenges and benefits of this approach, particularly in light of current market uncertainty? 

Chris Long: The movement towards pre-cessations triggers is being motivated by the market’s need to address the problem created when the regulator deems a benchmark rate to be non-representative without an appropriate fallback in place. Without a pre-cessation trigger, market participants would need to immediately address the ‘non-representativeness’ determination and move their existing exposure to a new reference rate. The selection of a new rate would need to be amenable to all parties of the contract, and be compliant with benchmark standards or regulatory requirements for benchmark use. Having a pre-cessation trigger linked to fallback language certainly alleviates a number of these issues. The inclusion of pre-cessation language in all contract types will also avoid the problem if linked contracts don’t fall back in lock-step, introducing basis risk, hedge accounting issues and operational nightmares. The inclusion of pre-cessation language certainly has a number of advantages, but is not without its challenges. The determination of non-representativeness does not necessarily mean permanent cessation, which implies Libor can be published for a period of time following the ‘non-representativeness’ trigger. This will add confusion to market participants unprepared for the change. 

 

What steps should firms take to prepare for Libor transition and how are firms coping with the operational challenges involved?

Chris Dias: There are a number of operational factors that must be considered as organisations prepare to transition away from Libor. Continued uncertainties in the market coupled with the breadth of the impact requires firms to be agile and plan effectively to be operationally ready for new RFRs. Firms should consider changes and updates required to processes, systems and models to be operationally ready to book new products in the RFRs in alignment with market and industry timelines. The steps firms should consider include:

• Establishing a new product strategy and implementation working group to drive operational planning and implementation efforts
• Defining business strategies and timelines for reducing reliance on Libor for new product issuance, including the selection of RFR alternatives and offerings
• Ensuring each business line – and for core functions such as finance, treasury, inventory technology, operations and modelling tools – understands specifically where they are using Libor
• Defining requirements and implementing capabilities to build SOFR/other new-rate financial products that will replace Libor products
• Co‑ordinating change management for internal systems, models and vendor software releases, changed data interfaces and system replacements for those unable to support the Libor transition
• Building testing plans for new product capabilities, models, model validation and the operationalisation of fallback processing
• Undertaking conduct-readiness assessments for systems changes, data management, operational procedures, final communications, product releases and transition go-live. 

 

The panellists’ responses to our questionnaire are in a personal capacity, and the views expressed herein do not necessarily reflect or represent the views of their employing institutions

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