Sunsetting IBOR
The use of Interbank Offered Rates (IBOR) has dwindled in recent years as fewer banks rely on interbank funding sources. As a result, continued use of IBORs has prompted on-going concerns, with regulators around the globe pressuring banks to pursue new benchmark rates that are market based and mitigate risk of market manipulation (click here for more information on the new rates). As of today, a significant number of banks continue to use IBORs to price billions (USD) in derivatives, and debt exposures. Sunsetting IBOR and transitioning to alternative risk-free rates (RFR) requires banks to build, strategize, and execute amid industry-wide uncertainties and challenges which now includes a global pandemic. Despite repeated calls by industry participants to extend the 2021 end date set by the UK Financial Conduct Authority (FCA) due to the ongoing COVID-19 crisis, there have been no indications that the deadline will be extended. Global regulatory bodies are currently focused on mitigating the immediate impacts of the COVID-19 virus and it is unclear when and how extension requests will be addressed.
Executing an IBOR Transition Program Amid Uncertainty
A program of this size will have a profound impact on many people, processes, and technologies. To ensure readiness, it is vital for banks to execute a plan that is aligned with industry-wide guidance and meets regulatory expectations. In the U.S., the Alternative Reference Rate Committee (ARRC) plays an integral role in providing guidance to the private market participants responsible for ensuring a smooth transition to the Secured Overnight Financing Rate (SOFR). ARRC recommendations are generally specific to sub-stakeholder groups such as the loan, securitization, accounting, tax, operations and infrastructure, client outreach, and communications teams. The industry guidance provided by the ARRC aims to reduce the systemic risk of disruptions due to the sunsetting of IBOR. The collaboration between private market participants around the globe is essential for individual banks to execute their strategy in concert with their clients and competitors.
Transitioning Legacy Trades and Preparing for New Product Offerings
Although derivatives generate an overwhelming majority of IBOR-referenced exposures today, it is important to consider the underlying market fueling the demand. Deemed by some as the “$12 trillion-dollar headache for Loan Bankers”[i], the IBOR transition program is a massive endeavor. Ensuring transition readiness is critical for a well-functioning primary loan market and for the development of a liquid derivatives market that allows banks to hedge their exposures. The first step in executing an IBOR program for both new and existing loan exposures is to determine the number of IBOR related exposures and the total gross notional value across the various Lines of Businesses (LOBs). As a next step, banks should rank exposures by LOBs, asset class, product type (i.e. loans, derivatives, etc.), and risk characteristics (i.e. ratings, expected losses, etc.). This allows banks to prioritize their IBOR transition work and place initial focus on the legal agreements and systems with the largest exposure concentrations.
As illustrated in the Chart below, building cross-business and geographical transition groups allows for priorities and transition recommendations best suited for the associated LOBs and regions itself. For example, the U.S. will have a benchmark rate and implementation timeline that differs from the one in the U.K. When constructing the enterprise-wide transition plan, it is important to divide the plan into (1) Legacy (i.e. back book) exposures vs. (2) New originations (i.e. front book) work efforts. The enterprise-wide plan will vary depending on this categorization and will need to be validated and signed off prior to moving into the execution phase.
Finally, the IBOR transition program should execute all system enhancements to support the new RFRs. Recalibrating and revalidating pricing and risk models, modifying existing underwriting and accounting systems, and leveraging NLP for data mining agreements are all activities that should be actioned in preparation of sunsetting IBOR. This will greatly reduce the risk of delays, funding approvals, resource gaps, loss in client relationships and market share, and mitigate legal and regulatory ramifications.
System and Model Enhancements
IBOR benchmarks are deeply entrenched in a wide range of pricing and risk models that extend to operational processes and financial and risk reporting applications. As a starting point, IBOR is widely used as a discount factor in the valuation of loan and derivatives products. Many pricing and risk models will need to be recalibrated and re-validated to accommodate the transition to RFRs. These changes will flow through to a number of downstream calculations, data feeds, and reports that will need to be reviewed and modified to reflect the inherent differences between IBOR and RFR benchmarks. As an example, the lack of forward-looking RFR rates will impact the timing of a wide range of processes that leading banks have automated in recent history. In addition, modifying accounting and underwriting systems is necessary to support new functionality such as calculating compounding interest in arrears. It is no exaggeration to say that the pending system and model changes will be felt deeply across entire banking organizations.
Legal Agreement Remediation
Ensuring Adequate Fallback Contractual Language is in Place
Fallback language is the language found in contracts that details the appropriate replacement rate (i.e. SOFR) necessary in the event the existing rate is no longer available (i.e. USD LIBOR). Fallback language is critical to ensuring that existing loan agreements and derivative contracts (i.e. ISDA) can transition away from the legacy IBOR rate to the new RFR benchmark. The absence of clear fallback language in agreements results in significant legal and reputational risks. As of today, millions of legal agreements do not include the adequate fallback language necessary to ensure certainty and protection for all parties.
In the U.S., the ARRC have issued numerous consultative papers outlining the recommended fallback language banks should apply when executing their transition plan. Banks should work closely with legal and compliance partners to amend and update all contractual fallback language across the full population of legal agreements that currently reference IBOR rates. For legacy exposures, banks should include the necessary language stipulating the new replacement rate (i.e. SOFR in the U.S.) and the ‘spread adjustment’. The ‘spread adjustment’ is a static (and soon to be published) rate that accounts for the liquidity and risk differential between legacy (i.e. back book) exposures and the post-transition RFR benchmarked positions.
Leveraging Natural Language Processing (NLP)
The IBOR transition program can capture operational efficiency and reduce overhead costs by leveraging NLP technology. NLP technology allows banks to process large volumes of loan and derivatives agreements by identifying and extracting key IBOR reference fields. Utilizing NLP saves countless hours from operational support staff and improves the speed in which loan agreements can be transitioned to the new benchmark RFRs. The level of standardization for ISDA agreements allows sophisticated NLP tools to identify and extract key terms quickly and without any major challenges. By contrast, wholesale loan agreements often lack standardization which limits the effectiveness and accuracy provided by NLP tools.
Given the tight industry deadlines of many global IBOR transition efforts, NLP can support the arduous and time-consuming manual data extraction efforts previously conducted by operational staff. A well-executed IBOR program can provide a bank with a competitive advantage as they gain an earlier view of their post-IBOR portfolio compositions and risk profiles. Although the long-term benefits of NLP tools typically outweigh the investment costs, it is important to set realistic performance expectations across the enterprise.
Banks should anticipate the following common challenges and pitfalls when planning for their legal agreement identification, extraction, and amendment efforts through the help of NLP tools:
Dated documentation/low quality scans
Inconsistent loan agreements
Password protected documents
Water marks
Split documents
While sophisticated NLP tools can significantly reduce the manual review and extraction of key data fields, they don’t replace strong subject-matter and change management experience. Deploying experienced loan and contract auditors and performing manual “four-eye” inspections of NLP outputs remain vital to achieve accurate post-transition contractual terms across asset classes and product categories.
Demonstrate Market Readiness
The successful execution of IBOR transition programs is subject to ambitious industry deadlines and contains many uncertainties and pitfalls. Banks are well advised to ensure that they dedicate sufficient resources to their IBOR transition efforts. Falling behind on this work will make it challenging for banks to orient themselves in a post-IBOR world and will likely trigger increases in market, operational, compliance and legal risks that will that will be costly to mitigate. At this stage, IBOR transition is inevitable and the next few months will provide us with a clearer picture of overall market preparedness.
About Monticello
Monticello consultants have extensive experience in the implementation of large-scale regulatory initiatives. Our firm understands the importance of diligent analysis, program management, and collaboration across teams within major financial institutions and across the industry. Our current work on IBOR Transition, Uncleared Margin Rules (UMR), Qualified Financial Contract (QFC) Record Keeping and US Stay regulations demonstrates the important regulatory expertise our consultants bring to our clients. Our teams possess deep knowledge of capital markets instruments, legal agreements and operational processes, as well as the related data and information systems impacts that will be in focus for the migration to RFRs. Monticello teams are dynamic, flexible, and highly motivated to assist you in your transition to a post-IBOR future.
[i] Analysis – The End of Libor Is a $12 Trillion Headache for Loan Bankers – Bloomberg, Jan 19th, 2020 – Jacqueline Poh and Ruth McGavin.
Get In Touch
LEARN MORE ABOUT MONTICELLO AND PURSUE OPPORTUNITIES WITH OUR TEAM