New report by Oliver Wyman says firms should start developing new non-LIBOR products and managing down LIBOR exposures; those that do not act quickly in anticipation of the transition will increase risks and costs.
Consulting firm Oliver Wyman has published a new report urging banks and other market participants to mobilise transition efforts away from LIBOR (the London Interbank Offered Rate).
LIBOR is the reference interest rate for at least USD 260 trillion in wholesale and retail financial products, ranging from complex derivatives to residential mortgages. It is also hardwired into all manner of financial activity, such as risk, valuation, performance modelling, and commercial contracts, the report says.
Significantly reduced volumes of interbank unsecured term borrowing – the basis for LIBOR – has called into question its ability to continue playing this central role. The UK’s FCA (Financial Conduct Authority) announced last year that after 2021 it will no longer compel panel banks to submit the rates required to calculate LIBOR.
According to the report, a transition away from LIBOR will bring considerable costs and risks for financial firms: “Since the proposed alternative rates are calculated differently, payments under contracts referencing the new rates will differ from those referencing LIBOR. The transition will change firms’ market risk profiles, requiring changes to risk models, valuation tools, product design, and hedging strategies.”
LIBOR may become unavailable even though products referencing it remain in force, it says, and relying on “fall-back provisions” for the remaining life of the contract will result in a significant economic impact, with one side a winner and the other a loser.
“Renegotiating a large volume of contracts is difficult, especially when one party has a contractual right to a windfall gain,” the report says. “If contracts are left to convert to fall-back provisions if LIBOR becomes unavailable, a vast number of price changes would occur in a short period.”
The associated financial, customer, and operational impacts will be difficult to manage for financial firms, including a serious communication challenge with retail customers (such as in mortgage renegotiations), who may lack an understanding of LIBOR and suspect proposed alternative rates represent a worse deal.
“Transitioning away from LIBOR could create considerable conduct, reputational, and legal risk. Even today, writing long-dated business that may extend beyond a LIBOR transition period entails conduct risk,” the report says. “Without clarity about the alternative rates or when the transition will happen, it is difficult to know how contracts should be priced. The longer uncertainty persists, the greater the mis-selling risk incurred by financial firms.”
According to Oliver Wyman, a wait-and-see approach is “unwise”, given the volume of products and processes that will have to change. Banks and other market participants with significant LIBOR positions should mobilise transition programmes immediately, Oliver Wyman urges.
“Firms that do not act quickly in anticipation of the transition will increase both their risks and costs,” and will be ill-prepared to manage customers and the ALM (Asset Liability Management) implications. They may also continue to build up exposures which reference LIBOR, increasing the amount of conversion work to be compressed into a tighter timeframe, which will exacerbate the disruption and attendant costs, the report says.
On the other hand, firm that move early to redesign products on new reference rates can choose to stop writing new business referencing LIBOR and start to convert existing contracts. Early movers will also have an opportunity to shape industry norms.
Oliver Wyman says firms must not use uncertainty, and the fact that the end of compelled rate submission is still three plus years away, as a pretext for inactivity: “Three years is not long to undertake a project that could cover hundreds of thousands of contracts and affect multiple business lines and every function in the organisation,” the report says.
Firms should engage with regulators and industry bodies to help shape the transition process and its outcomes, the report says, starting with responding to the ISDA consultation. They should also firm up their position based on internal impact analyses and reviews of customer needs, as well as start developing new non-LIBOR products and managing down LIBOR exposures.
The full report is available here.