IBOR Phase-out Plans on Track Despite Covid: Moody’s

But challenges remain, including limited liquidity in ARR markets, uncertainties on term rates and credit spread adjustments, and operational issues.

Banks and NBFIs are significantly more prepared for the phase-out of IBORs compared to a year ago, according to a survey conducted by Moody’s Investors Service.

All financial institutions surveyed this year now have transition plans in place, compared to only around two-thirds of banks and one-third of NBFIs (non-bank financial institutions) in last year’s survey.

In addition, 75% of banks and 82% of NBFIs say they are progressing through their transition plans on schedule despite the onset of the Covid-19 pandemic earlier this year. Financial institutions that said their transition plans are lagging in some areas attributed this to Covid-19 related delays in some intermediate transition steps.

Moody’s says transition governance is now “well established”, with most financial institutions reporting that their plans cover all existing and new contracts across asset classes and derivatives and that they have identified the products and systems that need updating for ARRs (alternative reference rates) by end-2021.

Most financial institutions also report having an effective communication plan in place for key stakeholders, including regulators, clients, investors and counterparties. About 80% of surveyed banks and 51% of NBFIs have a communication plan in place as part of their ARR transition strategy.

Readiness concerns

Still, respondents expressed concern about the readiness of clients who are more focused on how business will recover from the Covid-19 driven economic downturn. Banks are monitoring client readiness for final activation of contract transitions from IBORs to ARRs, but a final readiness assessment and development of action plans can only be completed once all definitive fallback protocols are accepted by the market.

While around 60% of banks surveyed have already issued floating-rate debt indexed to ARRs, NBFIs’ debt issuance has been very limited. Despite improvements on the bank debt issuance front, financial institutions’ aggregate exposure to IBOR-linked instruments remains high and has yet to recede.

The global recession has contributed to the increasing exposure to IBORs, given that borrowers increased drawdowns on existing credit facilities during lockdowns, and government stimulus programmes such as in the US used LIBOR to ensure smooth credit transmission.

Moody’s expects financial institutions with large and complex exposures to IBORs to incur the greatest risk transitioning to new benchmarks, and for transition risk to be lower for financial institutions with mainly regional or domestic exposures to jurisdictions where IBORs will not be immediately discontinued.

Such jurisdictions include Europe (EURIBOR), Hong-Kong (HIBOR), Australia (Reformed BBSW), Singapore (SIBOR will remain for cash products, SOR will transition to SORA for derivatives), and Japan (reformed TIBOR will remain in place but JPY LIBOR will be discontinued).

Pick-up by year-end

While ARR adoption in cash products is lagging, Moody’s says it will pick up by year-end in markets where IBORs are discontinued. For example, in the UK, financial institutions not transitioning quickly enough will be reducing their capacity to use the BOE (Bank of England)’s financing window, given that a gradual haircut increase will be applied on LIBOR-linked collateral starting from 1 April 2021.

Limited liquidity in ARR markets is considered the primary obstacle to a smooth IBOR phase-out transition for financial institutions. Term and spread adjustments will also be difficult to implement because contracts referencing LIBOR will no longer function per the original agreements, creating basis risk.

Fallbacks are expected to be widely adopted by the market, though financial institutions recognise that they should not be the primary vehicle of market transition. For derivative products, financial institutions expect to be in a position to update contracts with market-accepted fallback language once the ISDA (International Swaps and Derivatives Association) fallback protocol is out later this year.

Determining ARR term rates is another challenge, particularly for cash products such as loans and mortgages. In the US, the ARRC (Alternative Reference Rates Committee) expects a forward-looking, futures-based SOFR rate to be created by the end of June 2021; however, only if daily SOFR futures volume and liquidity have been sufficiently built up by then.

“Uncertainties on the term rate, whether in advance or in arrears, seem to be deterring market participants from adapting their loan contracts to new ARRs,” Moody’s says.

Spread adjustments essential

Another major hurdle is the spread adjustment to ARRs to account for liquidity and credit risk premiums in IBORs. For derivatives, ISDA has released a spread-adjustment methodology, but this should be calculated at the date of LIBOR cessation.

“The finalisation of credit spread adjustments is essential because spreads between IBORs and ARRs can widen in times of stress,” Moody’s says. “Beyond 2021, the lack of credit spreads in new risk-free rates could still create risk of high interest margin volatility for banks, as widening bank credit spreads have tended to partly mitigate falling risk-free rates in times of market stress.”

Since July, Bloomberg has been calculating and publishing daily-adjusted ARRs over several tenors as fallback rates for existing IBORs, and produces a spread adjustment calculated in line with ISDA and ARRC recommendations. Although indicative until final fallback rates are defined, Moody’s expect the Bloomberg fallback rates will help market participants transition faster to ARRs.

Another difficulty for banks and NBFIs will be to negotiate and amend contractual terms on a very large volume of bilateral loans, including mortgages issued to unsophisticated borrowers, Moody’s says. “If a fair fallback rate is not implemented in time, there is a risk that borrowers will end up paying more, resulting in litigation and conduct risk for lenders.”

Operational issues are another substantial impediment to the adoption of risk-free rates – with financial institutions reporting transition challenges in key areas such as valuation models, risk management analytics and processes, trading and treasury systems. Smaller counterparties and customers in particular may struggle to adjust their systems in time to facilitate timely adoption.

Most banks (85%) and NBFIs (60%) surveyed have planned their operational transition through a mix of vendor and in-house solutions, Moody’s says. However, banks and non-banks with tactical solutions to expedite the use of new rates internally may face lower transition risk compared to those that will have to wait on outside vendors for system updates.

The full report is available here.

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