By Manoj Reddy, Head of BFS Risk & Compliance & LIBOR Transition Practice for TCS North America

The world as we know is changing due to the onslaught and devastating impacts of the Covid-19 pandemic with a new normal being discovered with every passing day.  In this multi-dimensional transitionary phase, we are also expected to witness the transition of the world’s most referenced interest rate, LIBOR (London Interbank Offered Rate) into Risk Free Rates (RFR’s).  The replacement RFR’s are recommended by the RFR Working Groups as convened by the respective regulators across the globe.  LIBOR Transition is likely to impact a gamut of cash and derivative products globally.  The scale and magnitude of impact of LIBOR Transition is now well known in the industry.  There would hardly be any financial institution at this point of time, which may not have initiated any level of impact assessment or remediation approach to ensure smooth transition over to other RFR’s on LIBOR cessation. This article explores the impact of the transition on banks’ lending operations.

LIBOR has been heavily referenced in lending products globally over the last four decades, so it is much more deeply engrained in the financial system than commonly known.  A vast majority of lending products across Consumer, Business and Commerical Banking have all been referencing LIBOR as the underlying benchmark rate for their fixed & floating rate loan issuances.  Though there have been other reference benchmark rates like the WSJ Prime rate or Fed Fund rate, LIBOR has been the most prominent among them.  To further convolute the situation in the United States, in addition to SOFR, there are also other IOSCO (International Organization of Securities Commissions) compliant rates such as AMERIBOR, which some of the US Community and Regional banks are contemplating, and preferring as an alternate reference rate to fund themselves in the inter-bank lending market.  Banks and other Financial Institutions (FI’s) are trying to grapple through this challenging phase which warrants a clear strategy to be defined and implemented to transition over from LIBOR to other alternate RFR’s with minimal disruptions to their existing business operations and corporate clients.

Challenges for Lenders in LIBOR transition

• LIBOR and RFR’s such as SOFR, SONIA, €STR, SARON and CORRA are inherently different

LIBOR is a forward-looking rate with a well-defined and published term structure, whereas the RFR’s are backward looking and are overnight rates with no published term structure as of yet.  Also, given that LIBOR is an unsecured rate and the RFR for GBP (SONIA) & EUR (€STR)  are unsecured vs. USD (SOFR), CAD (CORRA), & CHF (SARON) being secured, there are significant challenges to the Risk community in managing cross currency lending via the trading of cross currency swaps.  These inherent differences are a big challenge for Risk Modelers and lenders to make a simple switch from LIBOR to an alternate RFR in their existing or new loan contracts.

• The term structure for RFR’s are currently under development

Currently though there are only overnight rates published for RFR’s, with no term rate structure available.  For example, we have Daily SOFR rates published by 8 AM on the Federal Reserve website everyday but there is no SOFR Term rate for 1 week, 1 month, 3 months, 6 months or 1 year similar to LIBOR, which makes it difficult for a lender used to forward fixing rates and transitioning to rates that would be unknown in the future (given the backward nature of RFR’s). For GBP, Term SONIA is currently in beta testing phase and awaits regulatory feedback and compliance from the Bank of England. For Term SOFR, this is only likely to be available in the first half of 2021. Nevertheless there is no guidance if both term rates will gain regulatory compliance in line with IOSCO principles, thus FI’s should not contemplate waiting, given the stringent conduct risk regimes outlined by regulators such as US State regulators and the Bank of England.

• Loan systems currently may not be ready to handle backward looking rate

Most loan servicing systems currently have been built to compute the accrued interest based on a current or forward looking interest rate and the outstanding balance, as against having the capability to compute interest rates on backward looking compounded and simple interest methods with shifts and lags factored in as well.  This is one of the biggest challenges for vendor systems who are continuously releasing a stream of patches to bring systems in line with the new RFR’s.

• Complexity around spread adjustments and potential conduct risks

RFRs are overnight rates with no credit sensitive component factored into them as they are interest rates that follow central bank policy.  To bridge this gap, the RFR Working Groups have recommended the usage of a spread adjustment which can be complex to interpret by the relationship managers themselves, let alone explaining it to their clients.  Also, given that the spread adjustment is driven by a five-year historic median, it is currently subject to widening & tightening of the spread between RFR’s and LIBOR, which can lead a client to believe that there are a lot of unknown complex pieces involved in how the rates are derived and applied.  This can increase Banks and FI’s exposure to conduct risk, if the incorrect margin and spread is incorrectly applied, by way of client complaints to regulators.

• Dilemma over using Hardwired vs. Amendment approach in contracts

If the uncertainty around the RFR’s were not challenging enough, the predicament around the approach to amend or repaper the contracts for the appropriate fall back language in loan contracts is making this transition even more complex.  Lenders have the option to either use a hardwired approach which comes with a lot of presumptions about future rates and is something which is more difficult to align a client to use, the alternative is to use an amendment approach which is flexible by nature.  However, this could add an operational nightmare for thousands of contracts to be amended at a future point of time, especially within a short period, when LIBOR cessation is announced by the Bank of England, an announcement that was originally scheduled for the second half of 2021 and that is now being possibly advanced to end 2020.

Recommended Strategies for Banks and other Financial Institutions

Given the amount of uncertainty and complexity surrounding the LIBOR transition,  it is important that the Banks and FIs explore all tactical and strategic options to cause minimal disruption to their existing borrowers, and new clients who are looking to avail credit in the period running up to LIBOR cessation.

• Clearly Defined Product Strategy

Banks and FI’s should have a clearly defined product strategy to ensure that they have factored in the newer RFR’s in their product design.  This requires a complete review of their existing product inventory and ensuring mapping to a clearly defined RFR plus the respective fallback spread, alongside their internal spread originating from COF (cost of funds) and risk related counterparty spread, to arrive at the final rate to be charged to the client per lending product.  Lending policies and procedures need to be amended accordingly to ensure there are no implementation gaps or potential client grievances, which may arise to conduct risk.

• Interim Rate Strategy

In the backdrop of tremendous amount of uncertainty, there is a need to have an interim rates strategy which can be reviewed periodically as we gain greater certainty around the RFR’s, Term RFR’s, and the spread adjustment that needs to be added.  Also, the option to move some of the portfolios to fixed rates should not be discounted either.  The rates strategy should also factor in using the appropriate simple interest or overnight compounded averages for various lending portfolios.

• Pricing Strategy for New & Existing Borrowers

Borrowers, especially when it comes to bilateral loans and syndicated loans are aware of LIBOR cessation and would want to be presented with all rate options for new loans.  LIBOR linked loans need to have a waterfall methodology to amend the contract at its cessation, using a number of options such as RFR’s that could reference SOFR overnight, index or average rates. For new loan origination on SOFR, ensuring the correct spread adjustment as determined by the lead in a syndicated loan is critical. Proposals from the LMA (Loans Market Association) are underway and are expected to be finalized in Q3 2020.

• System Readiness

Though most of the vendors of leading loan servicing systems are upgrading their interfaces and releasing specific RFR versions with the new RFR features, there could still be a significant lag in getting them deployed, tested and rolled out into production.  Banks should look to explore the options of a tactical interest rate calculator, independent of loan servicing systems, to ensure they can test & validate RFR interest rate calculations. It is highly recommended that for Banks and FI’s to retain their existing customers, and stay competitive in the market for new business, they have tactical interest rate calculators built out, rather than relying on vendor upgrades for RFR’s, as well as subsequent upgrades for spread adjustments and proposed hardwired waterfall business rules.

• Contract remediation Strategy

It is important that lenders have a clearly defined strategy in place for contract remediation for existing loan contracts maturing beyond 31 Dec 2021.  There are two approaches which Banks and FIs are contemplating, firstly the hardwired approach which basically ties the lender and borrower to a certain waterfall model of applicable rate that is defined well ahead of time and is easier to operationalize.  Secondly, the amendment approach is more of a wait and watch approach with the applicable rate being chosen and consent taken upon LIBOR cessation.  Though this sounds ideal, it can be an operational hazard with Banks and FI’s having to amend large volumes of contracts at the same time, especially within a short period of time leading to increasing transition risks.  It is not necessary to choose one approach at the enterprise level.   Depending on the portfolio, and underlying products the contract references, an appropriate approach may be chosen.

• Solution approach for Contract Remediation

It is recommended that Banks have different strategies for different portfolios when it comes to contract remediation.  Since adjustable rate mortgages and student loans in the US are fairly straight forward, there could be greater leverage of artificial intelligence or machine learning solutions to review and extract key contract terminology to accelerate the analysis and profiling process.  For some of the more complex bilateral and syndicated loan contracts, either a full manual or a hybrid of manual and cognitive tooling can be leveraged as an option for contract review, extraction of key terms and fallback clauses.  Also, contract remediation solutions should have case management functionality, drill-down dashboards, and client outreach workflows, with customer response management capabilities to enable complete effectiveness and integration.

Conclusion

Though there is still a lot of uncertainty around RFR’s, Term RFR’s, and alternate IOSCO rates, alongside an assortment of interest rate conventions, this should not limit Banks and FI’s from preparing themselves for LIBOR transition.  Technology should at no stage be considered as a limitation for the lending lines of banks to issue/service new loans, or renew existing loans on the RFR’s.  All options, including tactical options, should be considered in ensuring Banks and FI’s remain resilient and competitive in the run up to the LIBOR cessation date.  It is extremely important to stay plugged into the market and have the agility built into your business, systems and operations to respond to the dynamic demands of a LIBOR Transition program.

About the Author:

Manoj Reddy is the Head of BFS Risk & Compliance & LIBOR Transition Practice for TCS North America with an experience of more than 17 years in the areas of financial services, IT, and business consulting. Reddy has led several risk & regulatory consulting and implementation engagements for financial firms globally. He has provided both Regulatory and Strategic Business solution to his customers over the last decade primarily in the area of CCAR, Basel, Liquidity Risk and Enterprise Risk management and is currently leading TCS efforts in North America with respect to providing Business & technology solutions to BFSI customers in the LIBOR Transition and Risk management space.