Have you ever heard of LIBOR and LIBOR transition?
For many years, LIBOR or the London Interbank Offered Rate has been a longstanding benchmark.
It reflected current market conditions.
Large global financial institutions referenced it when they lend to each other in the international market for short-term loans.
Major banks have also used LIBOR as a reference index rate for a wide variety of consumer and investment products.
Especially for loans with adjustable or floating rate terms.
However, in 2017, the UK Financial Conduct Authority (FCA) declared an important thing.
It declared that LIBOR would no longer be required as a reference index rate for financial institutions.
This is largely because transaction patterns between banks based on LIBOR no longer happen as frequently as they did in previous years.
LIBOR has also been subject to critique as issues of manipulation deem it a less credible reference.
Results of LIBOR Transition
As a result, regulators no longer consider LIBOR as the most reliable index for banks.
The Intercontinental Exchange will continue to release LIBOR rates daily.
But it will stop publishing one-week and two-month USD LIBOR rates after 2021.
UK regulators are scheduled to replace LIBOR by June 30, 2023, with the Secured Overnight Financing Rate (SOFR).
The LIBOR transition affects numerous financial operations in banks.
Specifically risk setting, performance modeling, and valuation.
The transition will require banks to update their valuation tools and risk profiles.
Also, they should come up with hedging strategies that would account for the associated risks of lending.
That said, many banks have begun upgrading their financial risk management software.
This was to adopt various operational changes the transition requires.
To further understand why financial institutions need to prepare for the LIBOR transition, read on to learn more.
Challenges with LIBOR Transition and Alternative Risk Free Rates
In place of LIBOR, they assigned Risk Free Rates (RFR) for every currency that has been using LIBOR.
RFRs are benchmarks based on overnight deposit rates that have a greater volume of recorded transaction data.
Thus, these are regarded as a reliable reference rate for banks. SOFR, which will replace LIBOR in 2023, is also a type of RFR.
They release RFRs locally at different times of the day while LIBOR is published in London each day at 11:00 am for different currencies.
Financial institutions must anticipate issues when they start calculating loan prices and asset liabilities with their RFR.
Mainly, RFRs do not account for the credit risk premium that they typically include in LIBOR.
These reference rates do not project the same premium for credit risk or term liquidity that banks are accustomed to.
So when banks calculate interest using RFR for contracts over an agreed term, the interest is usually lower than interest generated with LIBOR.
Banks and borrowers must then agree to some form of spread adjustment to account for term and credit risk.
Note that RFR is a backward-looking rate, not a forward-looking rate like LIBOR.
This means it cannot provide pricing guidance based on how a financial institution is handling credit risk for the length of time a loan goes with interest.
Another concern with RFR is the lack of term fixing.
Banks cannot analyze the reference term structure as they can with LIBOR, which typically fixes terms for 12 months.
Overall, this can make it difficult for borrowers to budget their payments accordingly.
And for banks to navigate proper risk exposure for lending products.
How LIBOR Transition Affects Asset Liability Management
Asset liability modeling requires bank officers to provide expected interests and capital cash flows.
This is for balance sheets to enable the production of key risk indicators.
As such, many balance sheet items have the basis of Interbank Offered Rate (IBOR) indexes.
And with the transition from LIBOR to RFR, financial institutions must compare and analyze spread differences.
Differences that are between IBOR and RFR overnight rates.
To generate thorough comparison and analysis, analytics programs are highly critical for banks.
For instance, analytics results might reveal a bank is prone to rate shocks.
Since RFR can be more volatile compared to LIBOR when used in any currency, some banks may struggle with the required adjustments.
To adopt LIBOR transition faster, many banks have upgraded to financial risk management software.
The software that allows asset-liability officers to input necessary factors for analysis.
Powerful computing and analytics can also support several forecasting methods.
In addition, they can perform extensive stress testing to project RFR with or without term structures.
As a result, it can boost data preparation and enable bank officers to focus on analyzing relevant risk insights.
It also strengthens regulatory compliance while allowing banks to track their metrics.
Importance of Engaging with Major Stakeholders
Apart from the impact of LIBOR transition on risk management, financial institutions must communicate the changes to key stakeholders.
Facilitating timely communication is crucial in helping stakeholders understand how the changes can affect their investments moving forward.
Banks must realize that the process is not a straightforward transition, and clients are likely to have their contracts reviewed for renegotiation.
And because each loan product entails its own documentation, it would require further negotiation between new borrowers and banks.
Overall, financial institutions should be straightforward in explaining how the LIBOR phase-out might affect investments.
They should also take time to review contracts and exercise the appropriate disclosure to their clients.
Communicating with major clients as early as possible will help banks avoid misunderstandings and complaints related to the LIBOR transition moving forward.
Banks should take the time to update their systems and recalibrate operations in preparation for the LIBOR phase-out.
This is also an opportunity to work with regulators to propose changes that can influence the transition process for a better system.
The earlier banks employ changes required for LIBOR transition, the more they can plan efficient processes that work for their organization.