Absence of Term RFRs Could Impair Risk, Forecasting Functions

Banking functions involving risk analytics and cash flow forecasting will need to change to accommodate risk-free rates, says Karen Moss at Moody’s Analytics.

The shift away from interbank offered rates (IBORs) towards risk-free rates (RFRs) is well underway. Derivatives market fallbacks have taken effect and regulators have started to put in place hard deadlines for when new product issuances referencing IBORs must stop.

The UK Financial Conduct Authority (FCA) has also now confirmed the end dates for all LIBOR settings, clarifying that UK regulated entities may not use LIBOR in new contracts after end-2021, even though publication of some settings may continue for a certain period afterwards.

For banks, much of the recent focus around the phasing out of IBORs has been on implementing fallback rates in existing contracts, issuing new products based on RFRs, and renegotiating new contract terms with clients.

Despite this progress, banks in most jurisdictions have not yet dedicated adequate time to consider the impact of the transition within risk disciplines that rely on forward-looking term rates for forecasting.

Karen Moss, Director, Balance Sheet Management Franchise, Moody’s Analytics

Karen Moss, Director, Balance Sheet Management Franchise, Moody’s Analytics

“Asset and liability management (ALM), funds transfer pricing (FTP), interest rate risk in the banking book (IRRBB), stress testing – these are all areas where yield curves are necessary, because they involve cash flow forecasting and discounting,” says Karen Moss, a Director at Moody’s Analytics specialising in bank balance sheet and treasury management.

“Banking products can reference overnight rather than term rates, but the latter are still necessary for risk analytics.”

Depth and liquidity

To date, the lack of forward-looking term rates for RFRs has been largely a concern in cash markets (particularly in trade finance), given that term structures have been the norm with IBORs for decades. Term rates are required to ensure loan interest and bond coupon payments can be known in advance, i.e. at the beginning of the interest period.

As markets shift away from LIBOR and other IBORs, most financial products will have to reference RFRs, which for the most part are only available as overnight rates. Most banks are expected to adopt RFRs using a compounded-in-arrears approach, however this would mean the rate used in interest payments would represent a historic state of the market rather than interest rate expectations, leaving counterparties more vulnerable to interest rate risk.

This issue has resulted in many trade finance and corporate bankers adopting a wait-and-see approach to the transition, waiting for forward-looking term rates to be developed for RFRs. Term rates can be extrapolated from a combination of RFR futures and swaps transactions, however a lack of liquidity in these markets has so far hindered progress in most jurisdictions.

The UK is one market where forward-looking term rates have been developed for RFRs. In January, ICE Benchmark Administration (IBA) and Refinitiv both started publishing term SONIA rates in one-month, three-month, six-month and one-year tenors, adopting a waterfall approach to ensure robustness. Both IBA and Refinitiv are currently negotiating licensing agreements with banks looking to use these new rates.

In the US, CME Group has started publishing forward-looking term rates derived from end-of-day SOFR futures prices. However, these rates are so far just indicative and cannot yet be used in commercial contracts as they are not calculated in a way that is considered compliant with International Organization of Securities Commissions (IOSCO) principles.

IOSCO-compliant term SOFR hinges on the SOFR swaps market gaining additional depth and liquidity. Fortunately, recent market developments, including an increase in SOFR-linked issuances by banks, have given rise to expectations that SOFR swaps activity will be sufficient for forward-looking term rates to be made available within the first half of this year.

Asia progress muted

In Asian markets, however, progress toward making forward-looking term rates available has been more muted, in part due to the slower development of RFR derivatives. Generally, a forward-looking term structure cannot be developed until there is enough liquidity across tenors in RFR derivatives markets.

In Hong Kong, regulators have said term HONIA rates will rely on the development of the overnight indexed swap (OIS) market. Yet, some participants believe the development of the HONIA swaps market is being hindered by Hong Kong’s adoption of a multi-rate approach, where the continuation of HIBOR will split liquidity between the two benchmarks. Currently there is no expectation for term HONIA to be made available this year.

In Singapore, term SORA rates are also not expected to be available in the near-term. The Steering Committee for SOR & SIBOR Transition to SORA (SC-STS) has instead suggested that, for the time being, market participants who desire forward-looking term rates use compounded SORA. “As there is no way to guarantee the development of such term SORA benchmarks, end-users should not delay their transition plans in anticipation of this rate, and should instead prepare to transact in products that reference compounded SORA,” the SC-STS has said in guidance.

Similarly, term TONA rates in Japan will depend on an active OIS derivatives market. However, as market participants are only due to cease issuance of new LIBOR loans and bonds by mid-2021, it is unlikely that the TONA derivatives market will be mature enough to allow the development of term rates by year-end.

Risk disciplines impacted

While the need for forward-looking term rates has been a focus for cash market products, banks have only recently begun considering the impact on risk disciplines that require yield curves for forecasting. In areas such as ALM, treasury, FTP, and stress testing, the adoption of RFRs will lead to additional complexities that most banks have yet to consider.

Most bank stress testing models, for example, are designed to forecast balance sheet impacts up to five years into the future. Meanwhile, new climate risk stress tests being piloted by regulators in the UK and elsewhere will require banks to extend these models up to 30 years. Currently, IBOR rates for the five major currencies are published for tenors up to 12 months. Where longer tenors are required, banks can use IBOR swaps rates which extend out to 30 years.

In Asia, such long-dated derivatives are virtually nonexistent for RFRs at this stage. A significant challenge for banks in interest rate and cash flow forecasting will be the inability to build a yield curve due to insufficient liquidity in RFR markets, particularly in the long end of the curve. As liquidity builds up in these markets, it will be increasingly possible to build out RFR term curves internally, however other challenges remain.

Chart: SOFR vs overnight USD LIBOR (April 2020 – Feb 2021)

Variations between interest rate conventions used in bond, loan and derivatives products will mean that as banks transition to RFRs, they will need to account for the basis risk between the different product types in interest rate models and forecasting. This will also have to be reflected in interest rate hedges, despite ongoing uncertainty around how these hedges will perform under future stress scenarios due to differences in price behaviour between RFRs and IBORs.

So far, RFRs have been known to behave significantly differently from IBORs, particularly in stress scenarios. SOFR, for example, has shown itself to be sensitive to repo market liquidity, resulting in significant spikes during fixing as a result of month-end and quarter-end liquidity issues. Amid the Covid-19 related stresses of 2020, SOFR became significantly more volatile relative to overnight USD LIBOR, with the former often rising when the latter fell, and vice versa. These factors will present further challenges for interest rate forecasting.

Naturally, much of the volatility seen in overnight RFRs can be smoothed out by using the compound average, such as over a 1-month or 3-month period. Yet, the lack of bank credit premiums in RFRs presents further concerns for banks. While IBORs incorporate credit and liquidity components and therefore tend to reflect increased risk during periods of stress, there is a general view that RFRs may stay flat, or even tighten, under the same conditions. One way to address this is for banks to embed spread adjustments in their risk management systems to ensure they are appropriately reacting to futures stresses in credit markets.

Looking ahead

Looking ahead to end-2021, banks need to understand how the transition to RFRs will impact their risk and forecasting functions, including how FTP should be recalibrated and how interest rate risk stress tests should be re-designed. Based on this, banks will need to review all their impacted risk policies, procedures and frameworks.

“Banks in Europe and the US are already thinking about this. For banks in Asia, there appears to be less of an awareness that they need to make changes in their risk and forecasting disciplines,” says Moss at Moody’s Analytics. “This is surprising considering that – even if the local benchmark is not changing – most Asian banks have exposures in US dollars, euros and other currencies where benchmark cessations are imminent.”

According to Moss, banks should source term rates from third-party providers, where possible. In jurisdictions where term RFRs are not available, banks will need to develop internal capabilities to calculate yield curves using market data that is available.

Moody’s Analytics won ‘Best Solution in Capital & Liquidity Modelling‘ in the Regulation Asia Awards for Excellence 2020.

More information on how Moody’s Analytics supports IBOR transition is available here.

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