Time is moving on for all Australian businesses who raise FX finance and are exposed to FX contracts that are benchmarked off the London Interbank Offered Rate or other IBORs that have till now been the benchmarks of choice. They need to work out their response to the expected discontinuance of LIBOR by end-2021.
With global regulator encouragement, the financial markets are moving away from using unrepresentative IBORs and are settling on the so-called alternative reference rates (ARRs) as more sustainable and reliable interest rate benchmarks. This transition is a mammoth global exercise for financial institutions and their counterparties and customers.
But this is not just an issue for lending banks or the structuring teams who plot derivative positions for financial institutions. All Australian businesses – including insurers, corporate borrowers, hedge funds or asset managers – who access the FX loan or swap markets need to consider their commercial and risk position in light of LIBOR transition.
The four to six months ahead of us are arguably the most critical in the transition away from LIBOR. The time to act is now. UK Financial Conduct Authority, Aug 2020
Many Australian organisations have started work to meet the end-2021 deadline for transitioning new and legacy products to ARRs. However, as they navigate their way through the transition process, a number of key non-financial risk issues are being encountered that will have consequences for them and their customers and will be keenly scrutinised by their regulators.
Major risk issues in a LIBOR transition
Organisations starting an IBOR transition programme are well-advised to make a thorough assessment of how IBOR benchmarks affect their business and to quantify LIBOR-related risks (as recommended by ASIC in its April 2020 release on LIBOR preparedness).
Any comprehensive impact assessment will depend upon, or sharply reflect, the following.
A LIBOR transition programme will need a strong internal governance framework to manage the process. Having this framework is critical to understanding the evolving risks that LIBOR transition brings to the business. Important elements of this framework mirror those that Kenneth Hayne emphasised in the Banking Royal Commission’s final report:
- The need for real accountability in terms of project direction and delivery (including the role that good record-keeping plays in demonstrating compliance).
- The need to generate the right information that flows to the right places in the organisation and that is used effectively.
Regulators are already sharply focusing on this aspect of a firm’s preparedness for LIBOR transition. The role of senior management, and ultimately the Board in ensuring that it challenges management properly on LIBOR, will be critical in ensuring that important risk exposures are addressed.
Managing conduct risk is at the top of financial institutions’ agenda in the aftermath of the various inquiries and reports into governance weaknesses in the Australian finance sector.
In the context of LIBOR, this is about whether the financial institution has acted properly and fairly toward its counterparties and customers when addressing the complex changes brought on by LIBOR transition.
One major issue is that the new ARRs are likely to be lower than LIBOR given the way they are calculated. This poses a problem for banks in proposing solutions to its clients to avoid ‘value transfer” that would otherwise prejudice the bank. This may well involve working out mutually acceptable spread adjustments and also addressing linked derivatives’ fall-back arrangements.
Key elements in considering a firm’s conduct risk position are:
- Regular and informative communication with clients. Firms will need to flex the style and content of this communication according to the audience, recognising the different needs of financial institutions versus corporate or retail clients and potential asymmetries of information.
- Reaching defensible (and recordable) judgments on how clients are treated fairly and with integrity when deciding how products should be adjusted.
- Communicating with regulators at regular intervals to alert them of plans, progress and challenges that are being encountered on transition – in itself a key aspect of regulatory strategy that all firms should be following.
Communication should be clear on what LIBOR transition means for clients and tailored to the sophistication of respective client segments ASIC, April 2020
Specific transaction example
LIBOR-based products are mature and familiar to market participants. However, some products referencing ARRs are still in an early stage of development with evolving market conventions. This creates risks for banks offering new products as well as for corporates and the buy-side generally in assessing them.
For example, a bi-lateral loan offered to a corporate borrower that refers to an ARR and that matures after LIBOR discontinuance, could throw up a range of issues including:
- Subsequent market developments could lead the customer to think they would have been better served by a different approach (eg a LIBOR loan up to the end of 2021 because interest payments might have been lower).
- Did the bank understand the client’s needs and situation so that it can be confident the right product solutions were fairly provided? How well did the bank explain the differential between LIBOR and the ARR?
- Quality of communication with client - were the right product options offered with the right clarity and was the customer treated fairly (for example, in the calculation of the margin given the spread between LIBOR and the ARR)?
The way ahead
With the focus on risk-based supervision as practised by Australian financial regulators, a current priority for FIs must be preparing for the discontinuance of IBORs and the mitigation of major risks that will arise in this process. The antennae of the organisation have to pick up the nature and extent of exposures brought about by the end of the IBORs and help provide a mitigating solution.
The big issue facing organisations who are about to grapple with LIBOR is the potential complexity in issues and related solutions, especially in the area of conduct risk. The clock is ticking.