Are banks ready for the end of LIBOR?

Over the last 50 years, London Interbank Offered Rate (LIBOR) has been the most widely used interest rate benchmark in the world.

In July 2017, the Financial Conduct Authority, a regulatory body in the United Kingdom, announced that it will no longer compel panel banks to submit rates for the LIBOR after 2021. This has created fair amount of uncertainties for many banks and their products, like over-the-counter derivatives, exchange-traded derivatives, securitisation, floating rate notes, loans, mortgages, etc.

For most banks which are preparing for the LIBOR transition, they are likely going through the following cycle:

- Setting up the project or governance group: To get the sponsor to kick start the LIBOR transition project

- Impact analysis & develop action plan: Quantify & identify the transactions that are related to LIBOR & develop the action plan, including but not limited to:

• negotiating with the customer on the fallback language
• deciding on the new pricing arrangement
• ensuring system readiness and change operational workflow

- Transition: To stop issuing new LIBOR-linked products and start transiting to other alternative reference rates (ARRs)

- Monitoring: Actively monitoring the development, stay agile and adjust the action plan as and when necessary

- Cut over: To cease LIBOR products to fully transit to other ARRs

The success of the transition will largely depend on the impact analysis and development of the action plan. A lot of time will be spent on negotiating the fallback language and determining the new pricing. Even for a more developed reference rate like Secured Overnight Financing Rate (SOFR), there are still many questions & decisions that banks need to answer. 

“Issuers and lenders will face a technical choice between using a simple or a compound average of SOFR as they seek to use SOFR in cash products. In the short-term, using simple interest conventions may be easier since many systems are already set up to accommodate it. However, compounded interest will reflect the time value of money more accurately, which will become a more important consideration as interest rates rise, and it can also allow for more accurate hedging and better market functioning"*

Under the simple interest calculation, the daily interest for each day under the observation period will be added up to form the interest payable during the observation period. Most of the systems can handle this calculation method and this is easier from an operational perspective. 

As for the compound interest, it recognises that the borrower does not pay the interest back owed on a daily basis and the additional amount of interest owed each day is calculated by applying the daily rate of interest to both the principal borrowed and the accumulated unpaid interest. 

“Users need to determine the period of time over which the daily SOFRs are observed and averaged. An in advance structure would reference an average of SOFR observed before the current interest period begins, while an in arrears structure would reference an average of SOFR over the current interest period"*

While interest in arrears can better reflect the actual interest rates over the period, it provides very little visibility of the total payment before it is due. To overcome this issue, especially for those contracts with longer periods, some hybrid calculations have been evolved. These include arrears with true up, delay billing, lookouts and lockbacks, etc.  

• Arrears with true-up – use a proxy compounded rate. After the interest period, calculate the actual compounded rate for the period and bill the difference as a true-up on the next payment date.
• Arrears with delayed billing – compute the compounded rate at the end of the interest period and give the borrower an agreed timeframe after the interest period to process the payment​.
• ​Arrears with (x-days) lookouts – use average reference rate for over interest period but the rate for last x days are equal to the rate x days before the end of the interest period. 
• Arrears with (x-days) lockbacks – use average reference rate for period lagged x days. The observation period form which rates are taken start before the beginning of the actual interest period.

To complicate the matter, some banks customers insist to have a term floating rate; some on the other hand, have simply decided to switch to fixed rate. Banks' decision on the pricing mechanism can also be affected by other banks which co-financing currently exist. While some of the ARRs have slowly developed some form of term rates in the market, not all ARR have the same maturity. Until today, there is still no consensus from all banks on the method of repricing. Hence creating some confusion and delay in decision.

As the decision of pricing mechanism is still fluid, the hedging mechanism needs to be adjusted accordingly. Some banks have chosen other alternatives including entering a macro hedge instead. Some simply wait for the market to develop new hedging instruments. Questions like how to hedge the term fixed rate with daily compounded interest, how to deal with arrears vs advance, how to manage the basis risk,  how to deal with the inconsistencies arising from the new pricing and the past hedging remain to be further studied.

In summary, as LIBOR is expected to come to an end in slightly more than a year from now, banks will need to kick-start their transition plan, stay agile, get themselves up-to-date of the latest market development in order to stay competitive. Winning banks are those who can come up with a tailor-made solution and pricing for different customers.

Original content provided by BDO United Kingdom

* Extracted from 'A User's Guide to SOFR' published by the Alternative Reference Rates Committee in April 2019.