While financial institutions focus on handling the logistical issues arising from Brexit, another major global issue is bubbling to the surface.
While it hasn’t received anything close to the headlines triggered by Brexit, financial regulators will wind down the London Interbank Offered Rate (LIBOR) by year end 2021. Used as the reference rate for over thirty years, LIBOR is linked to more than $370 trillion in financial instruments.
For U.S. dollar-denominated markets, LIBOR is likely to be replaced by the Secured Overnight Financing Rate (SOFR) which is based on the cost of overnight loans secured with U.S. government debt. Another U.S.-based Interbank Offered Rate to complement SOFR is also being considered.
Most banks have a general understanding of the looming transition, but don’t fully grasp its scale and complexity. The introduction and adoption of SOFR may significantly impact their business strategies, products, policies, processes, operations, data and technology across clients, products and geographies.
An average-sized financial institution might have as many 70,000 LIBOR-based agreements such as ISDA (International Swaps and Derivatives Association) master agreements, bilateral and syndicated credit, securitizations, repo agreements, collateral agreements and consumer credit (such as ARMs and student loans) and deposits.
At the other end of the spectrum, a large international lender could easily have hundreds of thousands of such agreements. This is because of a built-in multiplier effect – a single loan syndication agreement could collectively have multiple references to LIBOR in the offering memo, underwriting agreement, note obligation, syndicated loan agreement and pricing supplement. Identifying and addressing that kind of exposure is a bigger challenge than many banks realize.
Additional challenges include revising rate management methodologies, identifying system replacement costs, reconciling data, rebalancing portfolios and managing multiple rates.
The shift will create considerable legal and reputational risk, particularly in the pricing and documenting of agreements for transactions dated beyond the 2021 transition period.
Regulators have urged financial firms to start planning their strategy but the response, to date, has been tepid. A recent survey of the financial industry found that one in ten market participants don’t know if they have any contracts that will be affected by the LIBOR transition, and over 80 percent have not yet started amending existing contracts to add fallback language.
Many banks are establishing a dedicated team to devise a plan of action and manage the many moving pieces. The first step should be to assess business and legal risk exposures. Some key areas for the team to explore: what key divisions need to be involved in program governance; what will happen with contracts currently referencing LIBOR; how are trading strategies impacted; how are finance and risk metrics affected; how will the overall client relationship strategy be altered; and what process changes are needed to handle the transition.
Banks should focus on three areas:
Talent. Banks with large volumes of legal agreements requiring revisions across products and businesses should start ramping up their artificial intelligence capabilities and human talent specialized in remediating LIBOR issues. Don’t wait until the transition date to begin acquiring the necessary expertise to transform your contract review process.
Automation. Artificial intelligence can be leveraged to automate routine functions such as initial review of contract provisions, model validation and process and policy changes. Automating repetitive high-volume tasks will free up legal, risk management, and compliance professionals to focus on LIBOR transition strategy.
Customer expectations. Institutional and retail customers will have different expectations of the LIBOR transition. Institutional customers’ trillions of dollars of derivatives, interest rate swaps and other assets benchmarked to LIBOR will have to be repriced and negotiated. On the retail side, consumer loan modifications and communications must be drafted carefully to avoid running afoul of Consumer Financial Protection Bureau rules regarding financial educational awareness, suitability, and unfair or deceptive practices.
By now, banks should be well on their way to identifying contracts which are linked to LIBOR, determining fallback positions and conducting thorough reviews of their loan portfolios. For the balance of this year, and into next year, the focus should be on acquiring talent, expertise and software to ensure a smooth transition.
Venetia Woo, Accenture, Principal Director - North American Regulatory Strategy Lead, Finance & Risk Practice