The industry-wide transition from London Interbank Offered Rates (LIBOR) to Alternative Reference Rates (ARRs) is rapidly approaching. Strong system integration testing practices, coupled with a comprehensive validation and verification strategy, are essential components for a successful transition. Failure to implement a robust testing framework risks inaccurate regulatory reporting, which often translates into loss of confidence of the overall program and may draw unwanted regulatory scrutiny. As a result, banks should ensure that their high-profile transition programs are sufficiently funded to support proper testing protocols and governance to detect and resolve defects, issues and bugs well ahead of time.
Testing Considerations in Wholesale Credit (Bilateral and Syndicated Loans)
As we enter the last quarter of 2020, product owners of both proprietary solutions and third-party platforms should be well advanced in their implementation of critical system enhancements. Figure 1 below highlights the key front, middle, and back office Wholesale Credit functions and systems impacted by the transition to ARRs. These areas will require rigorous front-to-end integration and regression testing to ensure that the implemented changes yield the expected results.
Figure 1 : Lending - Core Functions & Systems
To ensure firms are fully prepared to accommodate ARRs in the near future, they should put a testing framework in place that comprehensively addresses the following areas:
Multi-currency capabilities – All processes and systems need to be enhanced to accommodate the full range of new ARRs (e.g. SOFR, SONIA, ESTR, etc.), including holiday calendars and calculation standards. In addition to new ARRS, all LIBOR fallback rates that support the back-book conversion to ARRs should be considered across all tenors (i.e. 30-day SOFR, 90-day SONIA etc.)
Downstream interfaces – Credit, finance and regulatory reporting systems depend on feeds from upstream systems of record (SORs) or data lakes. It is critical that all data elements required by downstream applications are available in a timely fashion and are accurately mapped. In addition, downstream systems need to be enhanced to generate accurate ARR computations, notices and reporting outputs.
Lookback capabilities – All systems that perform calculations must be enhanced to support lookback functionality to calculate accrued interest at the end each interest period, as this will be used for most bilateral and syndicated loans. Firms may be tempted to shortcut the depth of their testing efforts, hoping that ARR term rates will be available in the near future. However, at this point, it is far from clear if and when term ARR rates will become sufficiently liquid to replace overnight benchmarks. Until then, banks need to accommodate backward-looking interest calculations across all asset classes, products and currencies.
Full end-to-end testing – To ensure a complete and comprehensive testing lifecycle, firms need to test logic and calculations across multiple dimensions, including deal level, aggregated level, daily interest level, and interest paying period level. This is especially important for accounting SORs that accommodate arrears functionalities.
Firms need to carefully design their test frameworks to facilitate collaboration across a wide range of stakeholders. In addition, testers need to be in a position to quickly and efficiently identify and remediate defects. The below tools and approaches are helpful in enhancing testing communications, tracking and resolution:
Use cases – Comprehensive use cases that are well understood by all stakeholders are a simple and intuitive way to reduce ambiguity and avoid misunderstanding between various development teams.
Automated testing capabilities – Deploying automated testing tools is critical to ensure all functionality remains intact after new enhancements are deployed. For instance, changes to existing accounting engine logic, cost of funds (COF) modifications made to underwriting, collateral, pricing, and valuation SORs are all new functionalities that require extensive testing. Automation tools can dramatically improve the efficiency of testing efforts and reduce operational testing errors.
Agile practices and tools – Properly designed Agile practices allow teams to create continuous feedback loops, ensuring that valuable functionalities are delivered in a timely fashion and according to business requirements.
Figure 2 below illustrates the current (i.e. LIBOR) vs. target state (i.e. ARR) all-in rate calculation for loan and lease accounting SORs that rely on rigorous testing practices. Introducing new functionalities and data attributes that result in changing business logic, such as the credit spread adjustment (i.e. the ISDA/Bloomberg published rate) to pricing, valuation and accounting SORs, requires thorough test execution, automation, and validation to ensure accuracy. It is critical that all data mapping and business logic are thoroughly validated and tested, with toll gates and testing milestones being met. Key functionality as it pertains to exposure identification/management, transition workflow(s), and middle and back office system integration must be tested to confirm existing LIBOR exposure amounts are being transitioned to the appropriate ARRs. Any discrepancies between target and future state results have real economic impacts for the overall market, individual firms and their clients. Any valuation changes need to be carefully researched so that they can be explained at a granular level.
Figure 2: Current State (without Credit Spread Adjustment - CSA) vs. Target State (with CSA) All-In Rate Calculations for Accounting SORs
What to Expect and How to Remediate Testing Issues
To manage the influx of testing issues across the universe of applications, firms should rank each application and each defect (i.e. high to low priority). This will aid in the management of issues, defects, and bugs. Prioritizing all defects, ensuring critical functionality be addressed and released first to ensure a “usable” solution is critical. Testing teams should look to leverage existing regression test scripts to ensure existing functionality is thoroughly tested, including updating documentation to share across testing groups.
Firms need to pay special attention in their integration of updated third-party capabilities. Integrating complex enhancements made by third party vendors into existing BAU processes inevitably leads to errors, exceptions, and defects. Testing teams need to be skilled in distinguishing between exception handling and edge cases on the one hand, and true defects on the other, as this will alleviate system and operational readiness pressures given the fast approaching LIBOR deadlines. Development groups should confirm that new third party capabilities are tested as soon as possible to allow vendors to remediate issues in due time. Organizations must work closely with the vendors to remediate issues for those highly customized solutions.
What’s Next?
As we look ahead to 2021, financial institutions should look to prioritize transitioning legacy agreements and contracts. As shown in Figure 1, loans that contain hardwired fallback (i.e. tough legacy) language should be examined to determine if agreement changes are absolutely required. Current conversations between industry groups, banks and regulators have yielded the idea of a “synthetic LIBOR” rate. If agreement on this topic can be reached, legacy loans conversions can largely be standardized. However, these conversations are on-going and there is no guarantee that a “synthetic LIBOR” benchmark will be available in the near future.
Leading firms will establish and deploy key performance indicators (KPIs) to monitor the performance of their testing protocols to ensure major toll gates are reached in a timely fashion. This will assist in determining the effectiveness of loans auto-repricing to new ARRs. Regardless of the organizations’ appetite to leverage robotics process automation (RPA) and/or natural language processing (NLP) vs. transitioning legacy loans manually, it is vital for organizations to track the level of accuracy and effectiveness of all transition fields and successor rates.
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 LIBOR 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 alternative reference rates. Monticello teams are dynamic, flexible, and highly motivated to assist you in your transition to a post-LIBOR future.
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