By Manoj Reddy is the Head of BFS Risk & Compliance & LIBOR Transition Practice for TCS North America.
The world as we know is changing due to the onslaught and devastating impacts of the Covid 19 pandemic with a new normal being discovered with every passing day. In this multi-dimensional transitionary phase we are also expected to witness the transition of the world’s most referenced Interest rate, LIBOR (London Interbank Offered Rate) into Alternate Reference rates as recommended by Alternate reference rate committees as convened by the respective regulators in the geographies across the globe. LIBOR transition is likely to impact a gamut of cash and derivative financial products across the globe. The scale and magnitude of impact of LIBOR transition is now well known in the industry and there would hardly be any financial institution which may not have initiated any level of Impact assessment or remediation approach to smoothly transition over to other Risk free rates on LIBOR cessation.
LIBOR has been heavily referenced in the Lending Products globally over the last 4 decades so it is much more deeply engrained in the Financial system that commonly known. A vast majority of Lending products across Consumer, Business and Commerical Banking have all been referencing LIBOR as the underlying benchmark rate for all their floating rate Loan Issuances. Though there have been other reference benchmark rates like the prime rates or Fedfund rates, LIBOR has been most prominent among them. To further convolute the situation in the United States, In addition to SOFR there are also other IOSCO compliance rates such as AMERIBOR which some of the community and regional banks and lenders might be contemplating and preferring as the Alternate reference rate as that is what they currently use to fund themselves. Banks and other Financial Institutions (FIs) are trying to grapple through this challenging phase which warrants a clear strategy to be defined and Implemented to transition over from LIBOR to other alternate Risk free rates with minimal disruptions to the their existing Business and customers.
Challenges for Lenders in LIBOR transition
- LIBOR and alternate Rates such as SONIA and SOFR, SONIA and CORRA are inherently different
LIBOR is a forward looking rate with a well-defined and published term structure whereas all of the alternate reference rates are backward looking and are daily rates which no term structure. Also given that LIBOR is an unsecured rate and the ARRs (Alternate reference rates) are secured rates, there is a significant difference in their published values. These inherent differences are a big challenges for Lenders to make a simple switch from LIBOR to an alternate rate in their existing or new Loan contracts.
- The term structure for alternate reference rates are currently not published
Currently though there are the daily rates for ARRs currently published, there is no term rate structure under which these rates are getting published. For example, we have Daily SOFR rates published by 8 AM on the federal reserve website everyday but there is no term rate structure such as SOFR rate for 1 week, 1 month, 3 months, 6 months or 1 year similar to LIBOR which makes it difficult to make the transition from LIBOR to SOFR. This is only like to available towards the end of the first half of 2021.
- Systems currently may not be ready to handle Non-term rate structures
Most Loan servicing systems currently have been built to compute the accrued interest based on an available interest rate and the outstanding balance as against having the capability to compute interest rates on compound and simple interest methods with shifts and lags factored in as well. This is one of the biggest challenges for lenders as their systems are today not built to take daily rates and average them out and then apply them to compute the accrued interest.
- Complexity around Spread adjustments and potential conduct Risks
Since ARRs are daily rates and do not have the credit risk component factored into them as they are secured rates as against LIBOR which is an unsecured rate. To bridge this gap, the Alternate reference committees has recommended the usage of a spread adjustment which can be complex to interpret by the relationship managers themselves let alone explaining it to the customer. Also, given that the spread adjustment is likely to be a moving average, it is subject to volatility as well which can lead a customer to believe that there are are a lot of unknown complex pieces involved in how the rates are derived and applied. This can increase the Institutions exposure to conduct risk by way of customer complaints to the Regulators.
- Dilemma over using Hardwires or Amendment approach
If the uncertainty around the rates were not challenging enough, the predicament around the approach to amend or repaper the contracts for the appropriate fall back language in the Loan contracts is making this transition even more complex. Lender have the option to either use a Hardwired approach which comes with a lot of presumptions about the future and is something which is more difficult to convince a customer on, or use an amendment approach which is flexible by nature but could add operational nightmare for thousands of contracts to be amended at a future point of time within a short period for the then prevailing market scenario around benchmark rates.
Recommended Strategies for Banks and other Financial Institutions
Given the amount of uncertainty and complexity surrounding the LIBOR transition, It is important that the Banks and FIs explore all tactical and strategic options to cause minimal disruption to their existing borrowers and new ones who are looking to avail credit in the period running upto LIBOR cessation.
- Clearly Defined Products Strategy
Banks and FIs should have a clearly defined Product strategy to ensure that they have factored in the newer alternate reference rates in their Product Designs and redesigns. This requires a complete review of existing product inventory and embedding them with a clearly defined benchmark rate, adjustment spread and other margin or customer spread to arrive at the final rate to be charged to the customer under each of their Lending products. The Lending Policies and procedures need to be amended accordingly to ensure there are no implementation gaps or potential customer grievances.
In the backdrop of tremendous amount of uncertainty there is a need to have interim rates strategy which can be reviewed periodically as we gain greater certainty around the Alternate reference rates, the term structure of the alternate reference rate, the spread adjustment that needs to be added. Also option to move some of the portfolios to fixed rates should not be discounted either. The rates strategy should also factor in using the appropriate simple interest or compounded averages of daily rates for various lending portfolios.
- Pricing strategy for New & existing Borrowers
Borrowers especially when it comes to Bilateral Business loans and syndicate loans are aware of LIBOR cessation and would want to be presented with all rate options for new loans. Loans with LIBOR as an option to amend the contract at its cessation or loans on alternate reference rates like SOFR with compounding or simple average and direct application of a bigger than usual Margin or customer spread. For completely new loans on SOFR, there might not be a need for a spread adjustment at all. The spread adjustment is only for those loans which are currently on LIBOR and customer on renewal would want to switch over to SOFR.
Though most of the vendors of leading Loan Servicing systems are upgrading their solutions and releasing specific ARR versions with the daily rate averaging features, there could still be a significant lag in getting them deployed, tested and rolled out into production. Banks should look explore the options of a tactical Rate calculator outside of the Servicing systems where the averaging of the SOFR daily rates can be carried out fed into the Loan servicing systems like the way LIBOR rates are supplied today. It is highly recommended that for Banks to retain their existing customers and stay competitive in the market for new customers they have tactical rate calculators built out rather than completely wait for vendor product upgrades for ARR and subsequent upgrades for spread adjustments and Hardwired waterfall business rule next year.
- Contract remediation Strategy
It is important that Lenders have a clearly defined strategy in place for Contract remediation for existing contracts for loans maturing beyond 31 Dec 2021. It’s largely two approaches which Banks and FIs are contemplating, the Hardwired approach which basically ties the lender and borrower to a certain waterfall model of applicable rate defined well ahead of time and is easier to operationalize. The Amendment approach is more of a wait and watch approach with the applicable rate being chosen and consent taken on LIBOR cessation. Though this sounds ideal, it can be an operational hazard with Banks and FIs having to amend thousands of contracts at the same time within a short period of time. It is not necessary to choose one approach at the enterprise level. Depending on the portfolio and underlying products the contract deal with, an appropriate approach may be chosen.
- Solution approach for Contract Remediation
It is recommended that Banks have different options for different portfolios when it comes to contract remediation. Since Adjustable Rate mortgages and Student loans are fairly straight forward, there could be greater leverage of Artificial Intelligence or Machine learning solutions to review and extract key contract term to accelerate the review and profiling process. For some of the more complex bilateral and syndicate loan contracts either a fully manual or a hybrid of manual and cognitive tool can be leveraged as an option for Contract review and extraction of key terms and fallback clauses. Also Contract remediation solutions should have a Case management, dashboards, and client outreach with customer response management capabilities for it be an integrated effective solution and accelerate the overall process.
Conclusion
Though there is still a lot of uncertainty around alternate rates and their form and format of availability that should not limit banks and FIs from preparing themselves for LIBOR transition. Technology should at no stage be considered as a limitation for the Lending Lines of Businesses to Issue or service new loans or renew existing loans on the newer ARRs. All options including tactical options should be considered in ensuring Business stays resilient and competitive in the run up to the LIBOR transition point. It is extremely important to stay plugged into the market and Industry and have the agility built into your Business, systems and operations to respond to dynamic demands of a LIBOR transition program.
