By Navin Rauniar, Partner in charge of LIBOR Transition, TCS.
Back in March, RegTech Insight explored the relation of FRTB and the LIBOR Transition. There is a strong relationship between both initiatives, and we now find COVID-19 adding further complexity to this relation, especially between the recent delays to the regulatory landscape and the impact to the LIBOR Transition
To ensure the flow of credit to the global economy, there have been a raft of regulatory statement delays announced across the financial services industry. Regulatory initiatives such as Standardised Approach to Credit Risk (SA-CR), Revised Market Risk Framework (FRTB), et al have been delayed to 1 January 2023 (see chart 1).
Chart 1: Regulatory Delays
Nevertheless, the elephant in the room remains the LIBOR Transition which mandates banks not to be compelled to contribute to the LIBOR rate after 1st January 2022. The Federal Reserve, Bank of England (BoE) and the Financial Stability Board (FSB) have reiterated their stance on firms not relying on LIBOR post 31 December, 2021.
Looking at these statements, the Financial Conduct Authority (FCA), BoE, and the members of the working group on Sterling Risk-Free Reference Rates (RFRs) issued a joint statement in March on the impact of coronavirus on banks’ LIBOR transition plans. The features of the statement state:
- “…end of 2021…should remain the target date for all firms to meet”.
- “…preparations for transition will be able to continue. There has, however, been an impact on the timing of some aspects of the transition programmes of many firms”.
Note the language around this being a ’target’ date. While the statement reiterates that transition should continue, it is contradicted by the statement around partial impact on implementation. In fact, industry experts opine project resources are being diverted to support ad-hoc business-as-usual activities across business and technology functions.
- “…segments of the UK market…made less progress in transition and are therefore still more reliant on LIBOR, such as the loan market…”.
The statement acknowledges that certain lines of business within institutions have made less progress, which is a positive development. The statement was reinforced by an update by the FCA releasing a statement end April 2020, reiterating the end date as 31st Dec 2021 and only that, an interim date of no LIBOR issuance on loans being moved from Q3 2020 to end Q1 2021.
Similarly, the Federal Reserve Alternative Reference Rates Committee (Fed ARRC) has acknowledged momentum and urged balance should be maintained in delivering the transition in these challenging circumstances.
Impact of COVID-19 on LIBOR and RFR rates
The COVID-19 crisis has impacted all asset classes, even resulting in assets being simultaneously liquidated at one point at the start of March 2020.
Several global currencies have a Forward Rate Agreement (FRA) based on 3M LIBOR – overnight indexed swap (OIS) spread, which is seen by many as a proxy for risks in the banking sector. The OIS is effectively the RFR. The FRA-OIS spread has significantly widened (see below) proving the criticality of LIBOR and its use as a proxy to ascertain funding, term premium, bank credit, and overnight rate risks. The excessive widening of the basis in stressed times is one of the main reasons behind the move to replace LIBOR.
Funding pressures are now being addressed by central banks, by the Federal Reserve in the US, the BoE in the UK, and the European Central Bank (ECB) in the European Union, where their respective balance sheets have been ramped up significantly (see Chart 3).
With Fed funds at near zero levels and 3M USD LIBOR at an all-time high at the end of March 2020, driven mainly by increase in commercial paper rates, basis has significantly widened. Institutions are currently analysing the basis to understand impacts across their respective lines of business.
The impact on the Secured Overnight Financing Rate (SOFR) is at a critical turning point. Despite the COVID-19 crisis, the RFRs are not exhibiting the volatility seen in the LIBOR market. Whilst repo markets are not showing funding stresses seen in the past (such as the September 2019 SOFR spike), SOFR is trading in the range of 0.01% to 0.03%.
From a Sterling perspective, the Sterling Overnight Index Average (SONIA) is trading in the range of 0.07%, in line with Monetary Policy Committee (MPC) expectations, but not exhibiting negative rate characteristics for now.
Impact of the delay of regulatory deadlines on the LIBOR Transition
As mentioned, regulations including FRTB have been postponed to January 2023, the exception being the LIBOR Transition which still stands at January 2022. What does this mean? Unfortunately, this means more complexity for financial institutions! Why? The FSB (Financial Stability Board) has stated there would be possible increased market risk capital requirements to ensure compliance with the BCBS revised market risk framework (FRTB).
Regulations such as FRTB and SA-CC/SA-CCR define the backbone of how underlying models for market risk & credit risk are built respectively. These models are applicable to the RFR’s and define the basics of how data is sourced and utilised.
The IMA (Internal Model Approach) is one example from the FRTB and utilises expected shortfall models, whilst specifying the capital requirements for risk factors that are classed as non-modellable. Within FRTB, operational processes, front office pricing, risk modelling and capital requirements are all inputs to the LIBOR Transition.
Where we need to model RFR risk factors, we need to ensure that the Risk Factor Eligibility Test (RFET) can be passed. An example is for SOFR, where we need to source the time series from April 2018 onwards, as well as build the respective proxy prior to April 2018. To ensure IMA approval for interest rate risk models, FRTB defines the data requirements for the time series for the risk factor:
- Identify for the risk factor at least 24 real price observations per year (measured over the period used to calibrate the current ES model, with no more than one real price observation per day to be included in this count). Moreover, over the previous 12 months there must be no 90-day period in which fewer than four real price observations are identified for the risk factor (with no more than one real price observation per day to be included in this count). The above criteria must be monitored on a monthly basis; or
- Identify for the risk factor at least 100 “real” price observations over the previous 12 months (with no more than one “real” price observation per day to be included in this count).
To build the SOFR time series, this will involve data sourcing, cleaning of market and reference data, sourcing of stressed period for SOFR, transaction-data pooling for Non Modellable Risk Factors (NMRF), as well as the pricing & risk modelling development, alongside production, reporting, and validation of models.
In summary, the Basel regulations that have been delayed are building block inputs to the LIBOR Transition (Market Risk, Credit Risk, Operational Risk). With these dates being postponed to January 2023, these outstanding requirements are being de-prioritised to free up credit for more critical COVID-19 related activities, and rightly so, to ensure the flow of funding to the economy.
As mentioned, the outstanding Basel requirements are inputs to the LIBOR Transition, so institutions now risk rolling out RFR products with partial compliance to regulations such as FRTB, and risk taking the RFR through a pre and post Basel phase.
Given Basel regulations such as FRTB being a building block for the LIBOR Transition, should this not mean the LIBOR Transition being delayed to January 2023 as well?