ECB report: Banks need to be prepared for all scenarios, including disappearance of EURIBOR

Introduction

On July 23, 2020 the European Central Bank (ECB) published its report on preparations for benchmark rate reforms (Report)¹. The report is based on an assessment of banks’ preparedness for benchmark rate reforms, which was conducted by ECB Banking Supervision in the second half of 2019.

Focus on EURIBOR

The Report states that banks had focused more on the transition from the euro overnight index average (EONIA) to the euro short-term rate (€STR) than on the reform of the euro interbank offered rate (EURIBOR) and the associated risks. This is probably due to the fact that EONIA will be discontinued on January 3, 2022 and replaced by the €STR, an overnight wholesale funding rate that is published by the ECB, while, on the other hand, EURIBOR underwent a methodological reform in 2019 and has been authorised by the competent authority, meaning that the benchmark can continue to be used for new and legacy contracts after January 3, 2022.

With regard to EURIBOR, the Report stresses that it is important for banks to be prepared for all scenarios, including the disappearance of this benchmark. The long-term sustainability of EURIBOR depends on factors such as the continued willingness of the panel of contributing banks to support it, and whether or not there is sufficient activity in its underlying market. So far, a different approach has been taken for the reform of EURIBOR than for LIBOR as the latter is being replaced by currency-specific overnight rates. Euro area banks operating in the global finance markets are aware of this reform and the different approach taken. The Working Group on Euro Risk-Free Rates (WG EUR RFR) is currently in the process of identifying potential €STR-based fallbacks for EURIBOR. It is expected that a proposal will be published for consultation in the coming months.

Fallback provisions

One of the best practices as identified by the ECB in its Report relates to fallback language – it is essential for banks to assess whether their existing contracts contain appropriate fallback language. Also, they will need to ensure that any new contracts entered into will contain such language.

We note that the use of fallback provisions in contracts was generally not required under EU law until January 2018, when the Benchmark Regulation came into effect. Before such time, fallback provisions were often originally intended to address the temporary unavailability of the relevant benchmark, instead of permanent cessation. The ECB recommends that banks check the fallback language contained in their existing contracts to assess whether those provisions appropriately deal with the scenario whereby EURIBOR is permanently discontinued.

For new contracts, the WG EUR RFR² has recommended that new fallback provisions should include a permanent cessation trigger event. In a similar vein, the Working Group on Sterling Risk-Free Reference Rates has recently published a recommendation³ stating that after the end of Q3 2020, all new and re-financed LIBOR-referencing loan products should contain clear contractual arrangements to facilitate conversion ahead of end-2021, through pre-agreed conversion terms or an agreed process for renegotiation, to SONIA or other alternatives.

Legislative solution?

On 24 July 2020, the European Commission published⁴ proposed targeted amendments which seek to create a new framework to have a statutory replacement rate in place by the time certain benchmarks (including EURIBOR) are no longer in use. A statutory replacement rate is a rate that the Commission can designate by law. Such a rate would take the place of e.g. EURIBOR in all contracts and financial instruments that mature after 2021. The power of the Commission to designate a statutory successor for the relevant benchmarks would only apply to contracts concluded by supervised entities, such as banks and investment firms, as these contracts are governed by the BMR.

We note that the proposed solution is a one size fits all approach and therefore will be a compromise position which some parties may not wish to rely on as it could be more advantageous to agree a negotiated position which has a better outcome for the relevant transaction. For this reason and the fact that regulated firms cannot rely on the legislation being put in place in time, firms should in our view still prepare to amend contracts and remediate the contracts that they can.

Best practices

A key feature of the Report is that it includes and sets out best practices that the ECB has identified through its assessment. These include, amongst others:

• Comprehensive risk assessment: Establishment of a comprehensive map of risk (i.e. in relation to bank’s business, counterparties, third parties, operational risks, financial risk management and regulatory and accounting implications).
• Project management:

• General best practices: Bank’s preparation work covers all critical benchmark rates, notably EURIBOR, EONIA and LIBOR as well as appropriate project documentation of each stage to ensure quality and consistency.
• Appropriate organisational structure: Use of separate, dedicated working groups for each area of activity and in case of complex structures subject to an operational framework that facilitates coordinated management across all parts of the bank. Involvement of senior management, in particular to approve project strategy, ensure appropriate resources, oversee implementation of the action plan, monitor progress and evaluate follow-up actions. After implementation, operational processes and risk framework to be reviewed by internal audit function, with clear feedback to the bank’s senior management and its supervisors.
• Risk identification: Development of a heat map for each risk category, showing the materiality level and related business area or support function. Distinction between material and non-material risks. Analysis of jurisdiction specific risks.
• Action Plan: Action plans as part of the dedicated risk assessment allow prioritisation of risk mitigation activities in a targeted manner. Action plan covers all aspects along the value chain and across the business. Action plans include a playbook, setting out worst-case scenarios and dedicated contingency plans for each relevant benchmark.
• Timeline: Project milestones are attached to a road map with clear start and end dates. Timeline accounts for the different transition paths.
• Budget and resources: Banks maintain a clear inventory of the resources they have allocated to the project and of the estimated costs involved. In case of external consultancy services necessary for the timely implementation of the action plan, such arrangement needs to be subject to appropriate governance and associated risks need to be taken into consideration.
• External developments: ECB expects all banks to fully comply with all legal requirements. Banks face the challenge of ensuring that they are up-to-date with the most recent developments. Banks to closely follow publications by the relevant public sector bodies. Cooperation across the banking sector is encouraged, in particular with implemented tried-and-tested solutions.

• Legal and operational challenges:

• Renegotiation and repapering: A central legal challenge for banks is that all contracts that are not compliant with the Benchmark Regulation are subject to renegotiation and legal repapering. Creation of specialised work units fosters high-quality repapering practices and ensures a smooth renegotiation of contracts. Workstreams to split into legacy and new contracts.
• Fallback language: Mandatory for all contracts issued after January 1, 2018 linked to a benchmark rate to include fallback provisions. Banks develop and implement fallback provisions (including with regard to EURIBOR). All contracts which already include fallback provisions are checked for compliance. Inventory is set up of all contracts requiring either the amendment or inclusion of fallback provisions.
• Communication strategy: Communication strategy has been rated as the most important risk mitigation tool for bank’s business. A disorganised communication strategy could trigger severe risks such as reputational and litigation risk. Communication strategy is developed and implemented as early as possible. Strategy to use different channels and to address different audiences (in particular internal and external).
• IT and risk infrastructure: Integration of alternative risk-free rates as replacement or fallback benchmark rates in banking systems and internal models can generate operational risks. Banks clearly identify all affected systems, affected exposures and related models. Assessment of IT support and infrastructure needed for repapering. Comprehensive adjustment process for the IT infrastructure. Detailed calibration and validation check on models.

• Risk relating to exposures:

• Identifying exposures: A high exposure to a benchmark rate is an important risk trigger for banks. A thorough inventory of all contracts and instruments linked to a benchmark rate can be useful in ascertaining the total exposure. Maintaining a comprehensive contract inventory with key information, in particular where information is otherwise spread across several IT systems and subsidiaries.
• Risk and compensation mechanisms: The euro area’s critical benchmarks are strongly linked to banks’ hedging strategies (including derivatives). Basis risk will have an impact on the marked-to-market value of derivative products and may trigger the need for compensation between counterparties. Banks implement widely accepted compensation mechanisms to ensure homogeneity and implement bilateral fallback trigger events in order to limit the risk of inconsistency with other market participants for bilateral contracts that are not subject to standard CCP arrangements.
• Accounting and prudential mechanisms: Under International Financial Reporting Standards (IFRS), the discontinuation of a benchmark may have significant accounting implications. Banks assess the material and potential impact on capital of the reforms and the potential implications of the modification or derecognition of financial instruments.

How we can help

At Norton Rose Fulbright, we have significant experience of helping firms with their Interbank Offered Rate (IBOR) transition programmes.

We have designed an end-to-end solution using a methodology based on project management best practice, supported by technology, specialist legal experience and regulatory and compliance advice, delivered via our global network.

Our integrated transition team consists of banking, finance and regulatory lawyers, compliance professionals, legal technologists, legal process architects, project managers and innovation specialists.

The Norton Rose Fulbright solution, which is built and tailored to a specific client’s needs, focuses on:

• How to approach transition e.g. planning and scoping the project or selecting the right technology tools.
• Assessing and managing the legal, regulatory, operational and business risk such a transition involves.
• Using technology to manage workflow, and reducing the time needed for manual document review and amendment.

We have extensive knowledge across our legal practice and also a dedicated risk consultancy which specialises in the practical implementation of change programmes across governance, risk and compliance. We have summarised below some of the key areas in which we can support clients in navigating the complex challenges in respect of IBOR transition.

Communications strategy

As noted above, a clear and robust communications strategy across all relevant stakeholders is of critical importance for managing and mitigating risk in respect of IBOR transition. We can support firms across various aspects of the development and delivery of an IBOR transition communications strategy. This includes, but is not limited to:

• Establishing an appropriate communications governance process.
• The identification and mapping of stakeholders, and their different requirements.
• Development of a stakeholder communication plan including:

• Internal stakeholder communication approach.
• External stakeholders (e.g. regulators) communication approach.
• Client/counterparty communication approach, including:

• An assessment of client and counterparty communication needs and capabilities.
• Development of a communication suite tailored to client/counterparty type.
• The timely scheduling of communications to clients/counterparties.
• Identification and development of training requirements for staff for dealing with client/counterparty queries.

• Communications strategy reporting and escalation arrangements to ensure the timely resolution of issues across stakeholder groups.

• Provision of advice on and support with communicating to regulators and responding to regulatory requests.

Risk analysis and management

Effective risk processes, underpinned by appropriate governance arrangements, are fundamental to informing the planning and successful delivery of an IBOR transition programme. IBOR transition programme plans should be “living” in that they need to consider risk across all key risk types (e.g. conduct, operational, legal, regulatory, reputational and financial) and how they are evolving on an ongoing basis to ensure that timely action and mitigation can be taken. We can support firms across various risk aspects including, but not limited to:

• Establishing appropriate risk governance and oversight processes relating to IBOR transition.
• Supporting clients with the identification and mapping of their risk universe and associated mitigation strategies in relation to IBOR.
• Undertaking “horizon scanning” across industry and regulatory bodies to support clients with the ongoing management of their risk strategies.
• Supporting clients in understanding their product governance responsibilities and associated risks arising (where relevant).
• Development of client/counterparty risk assessment approach and associated methodology.
• Undertaking client counterparty risk assessments and/or independently assessing the outputs.
• Advising on and developing appropriate management information and reporting to inform risk oversight and ongoing monitoring arrangements.
• Conducting lessons learned and post implementation reviews following the transition in order to ensure any issues are appropriately understood and fixed, and that learnings for future improvement can be embedded into processes going forward.

For further information and regular updates on IBOR transition, subscribe to the Norton Rose Fulbright Institute IBOR transition hub⁵.