IBORs are key to pricing and hedging a huge number of cash and derivative instruments, the impact of benchmark interest rates on the banking industry is likely to be immense.
Preparing for the benchmark rate transition requires banks to conduct detailed due diligence to understand their current portfolio of IBOR-linked exposures, products, operations, services, and strategies. Government authorities are encouraging the banking industry to draw up a detailed roadmap as soon as possible to transition to the RFRs.
Choosing the right ARR
Replacing the IBORs will naturally require banks to select a replacement from several alternative RFRs or identify a suitable proxy rate on par with their preferred benchmark rate. The RFRs are typically overnight and collateralised, meaning liquidity and credit risk premium needs to be added as a spread adjustment factor to bring it on par with an unsecured reference rate such as LIBOR.
The rates must be based on legitimate transactions, meaning substantial transactional liquidity is required to be built up on these rates using both cash and derivative products before they can be adopted as the official reference rate.
Bridging the gap between the benchmark rate and IBOR+
IBOR+ refers to a modified state of interbank reference rates aligned with the Financial Stability Board’s recommendations on overcoming the drawbacks of LIBOR. IBOR+ is formulated from transaction volume rather than professional judgment, with substantially tighter rate submission and publication processes.
To heighten controls around the IBOR+ submission framework and ensure rate-rigging malpractice is stymied, the banking industry will need to enhance their organisation-wide policies, process control frameworks, data, governance, and oversight in line with regulatory guidelines.
The industry should moreover look at reforming interest rate benchmarks in accordance with guidelines provided by the International Organization of Securities Commissions. During the initial stages of LIBOR cessation, however, the possibility of IBOR+ and the approved RFR being used simultaneously in a multiple-rate approach cannot be ruled out.
Evaluating LIBOR exposure and enhancing contractual robustness
The banking industry uses the IBORs as a reference rate for pricing and interest modelling across a huge volume of cash and derivative contracts. Identifying all the contracts that use these benchmark rates as a reference rate and modifying the fallback language for handling discontinuation scenarios is a huge and daunting task.
In addition, when fallback is triggered, spreads will need to be applied on the adjusted RFR to account for the credit risk premium component. Modifying contractual language to include fallback for cash products such as floating rate notes, mortgages, securitisation, business loans, and mortgages is likely to be complicated primarily due to the use of non-standard documentation.