It is time to put an end to the "procrastination syndrome" with the expiry of the London interbank offer rate. There can be no standing still.
Randal Quarles, vice chairman of the Federal Reserve’s supervisory authority, made it very clear in March that banks that delay the transition from Libor will bear the consequences.
Now we all know that this is not an easy transition. Tied to an estimate of over $ 200 trillion in global financial instruments, the Libor is the most widely used benchmark for short-term interest rates in the world. In the United States, the dollar Libor is the benchmark for certain bonds, financial derivatives, securitized products, and adjustable rate loans, including adjustable rate mortgages. Interest rate swaps linked to the Libor make up a large part of the business portfolios of some banks.
And unfortunately, it is not just about replacing the Libor with the secured overnight rate, an alternative that is advocated by the Committee on Alternative Reference Rates. In contrast to the forward-looking forward rates of the Libor, SOFR only looks back overnight. The SOFR is based on data from observable transactions and not on the estimated borrowing rates that were sometimes used in the Libor. If the Libor is used in new contracts, fallback clauses need to be carefully worked out to take into account the setting of the benchmark. Guidelines were published by the International Swaps and Derivatives Association (ISDA) in their IBOR Fallbacks Protocol 2020.
It is not a question of whether, but how soon the Libor will end. And Quarles' answer is sooner than you think. The organization overseeing the publication of the Libor, the ICE Benchmark Administration, has made it clear that it will stop publishing multiple versions of the benchmark rate after December 31, 2021. Publication of overnight, one-month, three-month, six-month and one-year USD Libor rates ends on June 30, 2023.
"After 2021, we believe that continued use of Libor in new contracts would create security and solidity risks and will review banking practices accordingly," said Randal Quarles, vice chairman of the Fed, in a recent keynote address.
While the discussion about the fall of the Libor began in 2014, the remaining panel banks that set the Libor agreed in 2017 to continue using it until 2021. So it has long been clear that the Libor would go away even if the end date wasn't so clearly set. That end date is now clear.
We should all note the recent keynote speeches by Quarles at the SOFR Symposium: The Final Year: "After 2021, we believe that continued use of Libor in new contracts would create security and solidity risks and we will review banking practices accordingly." We pause for a moment to ponder this statement. Assessing the security and soundness of a bank is everything.
Quarles expressed his dismay at the fact that "despite warnings from the official sector regarding the Libor, the use of the USD Libor has actually increased over the past three years". He clarified that "there is no scenario where a panel-based USD Libor will last beyond June 2023 and no one should expect it".
The Fed has published SOFR as a replacement for the Libor since 2018. So it's a bit of a headache: why haven't more US banks adopted SOFR or other available benchmarks for new contracts? Yes, there are difficulties in converting existing contracts. For new contracts, however, the calculation of the transaction-based SOFR is supported by a much more robust market than the judgmental Libor calculation. That makes it an attractive benchmark.
Operational challenges always slow down change. The complexity of term structures and compound interest, whether in arrears or in advance, to manage and operationalize the requirements is daunting. Accounting and hedging considerations make the transition even more difficult.
Nonetheless, as Quarles noted and reiterated in Federal Reserve Board SR 21-7, “should supervised entities fail to make reasonable progress in moving away from Libor, auditors should consider disclosing supervisory findings or taking other supervisory action. "
You can assume that Quarles' statements have been verified by the Federal Reserve. He is a cautious officer who means what he says. And it has now awakened the specter of a “regulate by enforcement” scenario in which the Fed could make an example for a bank that hasn't acted. Whether the penalty comes from the Federal Reserve, the Securities and Exchange Commission, the plaintiff's bar, or all three, it is likely to be severe. Inaction is the risk, the great risk. The consequences of inaction can be both financial and reputational. Imagine a dispute between counterparties over a billion dollar contract.
It is the job of a bank to deal with complexities. It is the job of a bank to protect its security and soundness and to mitigate financial risks in an inherently risky environment. Quarles has identified six important steps for banks to do. Note that these six shouldn't be consecutive but overlap and support each other.
· Develop a plan and establish a governance structure.
· Assess the financial risk and quantify contracts that fall back after the Libor was released.
· Identify and address operations, including systems, to ensure transition.
· If necessary, change contracts that could be negatively influenced by the discontinuation of Libor.
Communicating with counterparties, customers, consumers and internal interest groups in compliance with the requirements of the Law on Establishing the Truth in Lending Business.
· Providing regular updates to management regarding transition activities.
Quarles has also made it clear that the Fed will scrutinize banks on these issues and "the most important thing this year is that companies stop using the Libor."
If you had any doubts or further temptations to delay, Quarles has resolved those doubts or temptations. There is nothing left but to say goodbye to the Libor.