The Financial Stability Board have announced that disruption to markets caused by the COVID-19 pandemic must not stop banks from ending their use of the LIBOR interest rate benchmark by the end of 2021. Regulators worldwide have been engaging with the financial services industry to transition markets from LIBOR based interest calculations to Risk Free Rates (RFRs). This is being completed under a framework set out by the Financial Stability Board, representing the world’s largest central banks and regulators for G20 nations.
A key focus of reforms is to ensure widely used benchmarks are credible and robust. Regulators are clear that this means benchmarks should be based upon transactions. One of the most commonly known of these benchmarks is LIBOR, which is referenced by trillions of dollars’ worth of financial products, and used for calculating interest payments on bonds, loans, credit cards and mortgages.
As LIBOR underlying transactions have diminished, regulators have announced a target date to replace LIBOR and begun the process of identifying and creating alternative rates. However, these rates are structurally different from LIBOR and it is unclear how existing products referencing it will change, and what new products will emerge. There is a possibility of significant customer and economic impact and uncertainty over how this will develop.
The transition represents one of the biggest changes in the financial services industry ever, with an estimated $300tr of LIBOR global activity, covering derivatives, loans, bonds, trade, and working capital. Lenders and borrowers – will need to make changes in the months and years ahead. According to a paper from TCS, The End of the Road for LIBOR: Handling the Impact on the Financial World, readying for LIBOR transition will require banks to conduct a meticulous due diligence exercise to understand their current portfolio of LIBOR-linked products, exposures, services, operations and strategies. TCS say Banks would do well to start early and draw up a detailed strategy to transition to the new benchmark taking into consideration their individual agile and digital maturity.
Whilst uncertainty around the end of LIBOR continues to exist, the assumed base case scenario has to be LIBOR discontinuation for all currencies after 31 December 2021. This assumes a transition from LIBOR to alternative reference rates (ARRs) before the end of 2021. If there is still an inventory of LIBOR transactions at that point, there will be large operational and value transfer risks if LIBOR were to be discontinued. In this scenario, there may be a potential pressure for an extension, probably combined with a stop on any new LIBOR-based products. Any extension, however, has been rejected by several regulators and it would be risky to plan on this assumption.
So how is it possible to model for future and entirely unknown scenarios, what needs to happen, and what does progressive scenario planning for the LIBOR transition look like, as any deadline starts to creep closer? In a 2018 paper, LIBOR transition: Setting your firm up for success, Deloitte say Boards at Financial Services organisations should consider the following three steps for setting-up a LIBOR transition programme:
Firstly, mobilise a cross-business unit and geography transition programme, with C-level sponsorship. Deloitte say that in addition to accountable transition outcomes and activities, this must include accountability for decision making; for example, decisions on the timing of new product launches, or when to engage and transition certain customers.
Secondly, set out a transition roadmap. Deloitte’s paper highlights how LIBOR transition programmes should include various activities, but just as important a roadmap must identify key market and regulatory developments and milestones and track these. It may not be possible to take decisions or actions until specific developments occur, which will affect the pace of transition.
Thirdly, identify the risks and implement mitigants early. There are significant risks for LIBOR transition that leadership should be confident are being addressed. It’s vital to agree the mitigants to these risks and, subsequently, ensure that the effectiveness of mitigants is reported to leadership.
Given both the uncertainty and complexity involved, the LIBOR transition, will be one of, if not THE biggest transformation for the financial sector ever. It’s never happened before so there is no existing experience or roadmap for what different look like. Traditional Business Intelligence (BI) approaches and tools are essentially useless for trying to model what comes next for LIBOR, as they typically rely on data from what has happened in the past. Indeed, as far as LIBOR is concerned, relying on any existing BI tool, is the equivalent of looking in the rear-view mirror, as a huge truck hurtles fast towards your windscreen.
The good news is that instead of relying on traditional rear-view mirror approaches, technology now exists to better understand LIBOR data points and milestones, and analyse different potential futures to understand implications for LIBOR strategy, operations and value transfer, and take control of important LIBOR decision-making.
Milestones and mitigants can be scenario planned in unlimited LIBOR-transition plan versions and scenarios, including both operating and financial plans, making it easy to track the evolution of LIBOR transition plans over time and compare them with potential results.
It’s now possible to directly modify any LIBOR transition data model, during any planning or forecasting process throughout an entire integrated business planning flow, with the right decision-making platform. A newly created specialist business unit, such as the cross business, multi-geography LIBOR business unit outlined by Deloitte, or a game-changing decisions about existing LIBOR aligned products, or new ARR products, a new market or regulatory development, or modelling for different investments, can all be inserted in a controlled way during the LIBOR transition planning cycle, simulating the effect of any new transition scenario on the whole business model.
The path to transition away from LIBOR is complex, and there is no one size fits all approach based on pre-existing business intelligence tools. New alternative rates will be calculated on a different basis to LIBOR, everyone impacted is at different stages of transition, moving at different speeds towards, different outcomes. The consequences of reform are unpredictable and may have an adverse impact on financial instruments linked to any of these benchmarks. But the financial sector can embrace a new approach to scenario planning, capable of modelling various and new unknown scenarios looking forward, rather than pre-existing approaches based on rear-view mirror intelligence looking backwards.
The LIBOR transition, has the potential to highlight how some companies lack the processes and tools to make rapid decisions to address change, but it doesn’t have to be this way, and instead can usher in a new era of progressive scenario planning for financial service organisations who get it right.
By James Gannaway, head of financial services at Board International