By Adam Schneider and Serge Gwynne, Partners, Oliver Wyman
For 50 years, bankers have been using the London Inter-bank Offered Rate (LIBOR) in financial products, providing an efficient mechanism for pricing loans, hedging exposures and managing balance sheets. As a result, LIBOR is almost ubiquitous with notional amounts of approximately $240 trillion, and it has been called “The World’s Most Important Number”. But soon, no more: in 2017, Andrew Bailey, chief executive officer of the UK Financial Conduct Authority (FCA), announced that it would stop supporting LIBOR after 2021, and LIBOR may end at that time.
This sea change in financial markets affects all users of LIBOR, including banks, corporates, asset managers, insurers and consumers. A vast array of LIBOR positions will need to transition, and for that to happen, banks will need to create products using different reference rates. Banks and their clients will have to manage this change and a massive set of financial impacts.
This is a significant lift, and in our view, the transition requires executing three large-scale programs.
- Building a full suite of replacement products. Of course, these cannot use LIBOR, so regulators have created a series of alternative risk-free rates or alternative reference rates (ARRs) for such use. For example, the United States’ preferred rate is the SOFR (Secured Overnight Financing Rate), and the United Kingdom’s preferred rate is SONIA (Sterling Overnight Index Average).
- Managing existing LIBOR exposures (including those still being originated). This requires inventorying LIBOR usage (loans, derivatives, supporting technology, models) and creating the capability to either move to the replacement product or process fallback terms that apply if LIBOR is not available.
- Managing customers who need to understand both changes to existing contracts and the new replacement products.
Banks are tackling this problem with the support of industry groups, such as the UK’s Working Group on Sterling Risk-free Reference Rates, the US’ Alternative Reference Rates Committee, ISDA (International Swaps and Derivatives Association) and others. But it remains that the LIBOR transition is daunting. Why is that?
First, the scale is enormous. Interest-rate swaps utilizing LIBOR have a notional exposure of more than $200 trillion, and there are $10-12 trillion in loans using LIBOR. There are literally millions of loans and contracts affected. Any change of this magnitude entails high risk.
Second, at transition, all contracts using LIBOR will fall back to new terms, a situation sometimes dubbed “The World’s Largest Corporate Action”. Fallback language on existing contracts is often poorly worded, needs interpretation and changes contract economics. This is a difficult conversation for banks to have with clients. The industry has proposed better fallbacks, but these will not work for existing contracts without negotiation.
Third, basing new products on the ARRs changes the economics of lending as there is no easy formula to translate LIBOR to an ARR. LIBOR has both a term (30-day, 90-day…) and a credit spread representing bank funding costs. Products using LIBOR were built with these features. For example, a mortgage based on the one-year LIBOR includes an assessment of this term rate and the banking system’s funding cost. The new ARRs currently are only overnight rates and do not represent funding costs. They work very differently. As a result, any product using an ARR must be designed and priced differently than its LIBOR counterpart.
And, finally, renegotiating contracts that would otherwise “fallback” is clearly preferable to an unexpected change, but what would be the replacement? What are the current economics of fallbacks versus other choices? Are there “new” ARR products available? Most of these choices and strategies need to be developed.
Four considerations for the LIBOR transition
While banks and financial-product users continue to prepare for the LIBOR transition, we have identified three risks which need to be addressed, plus a significant opportunity.
- Prepare to process fallbacks—but also to negotiate.
Relying on fallbacks is risky since there will be almost certain value transfer between parties, and this will likely be contentious. Regulators have labelled fallbacks as a “seatbelt” and not a transition mechanism. They are right.
Negotiations to re-work existing transactions are better than relying on fallbacks but will be challenging. Banks will require a view of exposures to each customer/counterparty and the economic impact of transition, including changes to come through fallbacks. Banks will need to develop standard customer treatments, decision trees and playbooks to help manage a wide range of negotiations. Some products require 100% consent which is difficult to obtain. Meanwhile a fragmented approach may negatively impact relationships and lead to reputational damage, economic loss or worse.
Regardless, it is unlikely that banks can renegotiate all contracts, and so fallback processing for legacy portfolios will be required. As of this writing, we are not aware of any bank that has fallback terms in a database, let alone the ability to inform clients or calculate go-forward interest payments.
- It is imperative to proactively re-negotiate LIBOR contracts to reference an ARR. It is similarly imperative to stop selling LIBOR products as soon as possible—stop “digging the hole”.
- Banks also must understand what is required to process fallbacks and work to build this capability well before the transition. This is a major operational risk needing attention.
- Analytics will be key to conversations with clients, as they will rightfully ask, “What is the impact?” And these analytics will need to be built.
- Watch out for inconsistencies in fallback triggers.
While fallbacks may result in unintended consequences (e.g., floating-rate notes becoming fixed), they are reasonably consistent in terms of the trigger—the non-publication of LIBOR. Regulators and some market participants have indicated that a new trigger should be added that allows fallbacks to execute if LIBOR continues to be published but a regulator deems LIBOR unrepresentative. This is known as a pre-cessation trigger.
Pre-cessation triggers can easily cause inconsistencies in portfolios. For example, some derivatives users can opt-out of the proposed pre-cessation protocol. If part of the market does not sign on, there is a risk that a perfectly hedged book will change if fallbacks are partially triggered, creating basis risk.
- Understand the potential impact of inconsistent fallback triggers and terms.
- Proactively plan and assess the financial risk for inconsistencies in fallback terms if ultimately agreed to by the industry.
- Work with regulators and the administrator of LIBOR to try to minimize the timeframe between pre-cessation and cessation of LIBOR.
- Assess the impact of lending with a risk-free rate.
With many variables not known, most banks have not yet begun to quantitatively analyze the economic impact of moving to ARRs for new products. However, as ARR-based products will work differently and will have different risk characteristics, this needs intense focus.
There is no constant relationship between LIBOR and the ARRs. In particular, LIBOR-based products incorporate the increase in funding cost experienced in a time of financial stress. ARR-based products will not include this premium (the rates are “risk-free”), so ARR products will have lower interest income compared to LIBOR products in stress conditions. The reduction is meaningful and may be reflected in stress tests and other drivers of capital requirements. The problem is especially significant for non-US banks without a US deposit base that use wholesale funding to lend in US dollars.
This risk can be mitigated in several ways, perhaps by banks continuing to use a credit-sensitive rate or by banks pricing new products using ARRs in ways that reflect the risk. Either choice will require thoughtful analysis, education and communication with clients.
- Banks should develop the analytics to quantify the impact on interest income of moving to ARRs and use these findings to inform the design of their lending products and customer/market strategy.
- Building “what if” scenarios focused on sensitivities of cash flows is a central piece for such analytics and needs to encompass all levels of analysis, including for each transaction, for a product, for a client and for a line of business.
- A major opportunity: re-thinking pricing and propositions
LIBOR has been a great simplifying force in bank-product pricing; easy to understand, simple to use, effective to hedge. The transition to ARRs makes product pricing harder—currency rates will be less consistent, cross-currency transactions will require repricing, hedging may be less liquid, and each bank product may use different ways to adjust for term and credit spreads. However, moving off LIBOR also provides a once-in-a-lifetime opportunity. The transition allows banks to re-price a large portion of their loan books and rethink the customer proposition for new business.
This re-pricing potentially provides the opportunity to move to a more bespoke, relationship-oriented and custom-pricing strategy, through which specific deals can be better aimed toward detailed client requirements—but only if banks are ready. Historical examples of re-pricing in the context of dislocations in other markets reveal a huge difference in outcomes between participants who plan and execute pricing changes effectively and those who do not. For LIBOR, there are potential differences of hundreds of millions of dollars in profit for larger banks. Achieving this outcome requires a combination of pricing tools, performance analytics, sound governance and solid processes (including test-and-learn). Applying a conduct-risk lens will also be critical.
- Start preparing a customer proposition and re-pricing strategy and its implementation now.
- Build and understand analytic capabilities required to support re-pricing.
- Pilot the re-pricing strategy and quickly learn about customer reaction and choices.
- Focus on working with clients to proactively manage their existing LIBOR positions (since they should not want to go into fallbacks) into new products using the re-pricing strategy developed above.
The LIBOR transition is coming. If the current regulatory intent holds, it will occur early in 2022. Even if that is optimistic, it will likely only be delayed for a short period. We believe time is of the essence if products based on the new rates are to be created, and the back book to be successfully transitioned. Banks must gear up for this mammoth task—there is no time to lose.