The Libor Dilemma: How to Manage and Mitigate the Risks of a Tough Transition

The pending global shift from the Libor interest rate benchmark to an alternative reference rate is rife with legal, accounting, governance and technology complexities, imposing a heavy burden on financial institutions. But for savvy firms that are open to innovative ideas, there is one potential solution: a comprehensive, top-down transition approach that starts with a high-level assessment of the effect various replacement strategies have on trading, lending, funding and consumer products.

Today, with the 2021 deadline for the full switchover looming, many banks are still behind in their preparations. But the top-down approach can quickly and cost-effectively generate the full range of transition possibilities, allowing senior management to choose a few best alternatives to consider from the top-of-the-house perspective.

This type of holistic valuation of reference curve alternatives will help organizations with establishing internal governance, substantiating their communication with authorities, counterparties and customers. Just as importantly, it will reduce chances of legal, operational or reputational risk events.

To replace Libor, banks need to select the appropriate reference rate (or a combination of them) and determine what products should be replaced, when and how. The usual preparation process is bottom-up, with each of the bank's departments assessing the transition in its own area: e.g., measuring economic impact on cash flows and pricing; calculating risk; reviewing legal documents; and evaluating accounting implications. However, given the uncertainty on the final decision of what replacement curve(s) will be used, this is a tremendous amount of work.

Complicating matters even further is the final step of the flawed bottom-up approach: integrating the departmental calculations and considerations to derive the balance sheet implications of transition for the bank as a whole. If the balance sheet impact turns out to be unacceptable, the process is then repeated, with the departments going back to the drawing board and assessing the consequences of another alternative.

It should come as no surprise, therefore, that many banks are complaining there is not enough time to shift away from Libor. Regulators, moreover, are facing a hard conundrum: whether to extend the timeline (allowing further delays) or push the banks to comply (risking market havoc with increased volatility and reduced liquidity).

A Superior Approach

We suggest an “upside-down” approach that would allow banks to arrive at the replacement deadline on time, without causing chaos. This approach starts with the analysis of balance sheet implications of various reference rates, where potential volatilities and new behavioral patterns can be tested ahead of the implementation.

As they further consider alternatives, banks need to understand potential consequences of their choices. For example, during stressful periods, the Secured Overnight Financing Rate (SOFR) is likely to drop, as investors turn to overnight repo for safety. Borrowers, moreover, might accelerate drawing on unfunded commitments under such a scenario, increasing exposure- at-default (EAD) at the same time when their probabilities of default (PDs) and correlations between defaults are also rising.

Though top-down analysis has many potential benefits, it also has to deal with the absence of data reflecting the new regime. Risk models like value-at-Risk (VaR) are based on limited historical data, so estimates of risk valuations might not be reliable for the proposed alternative reference rates. (New rates, of course, will suffer from inadequate historical data in the immediate aftermath of replacing Libor.) Pricing models, moreover, also rely on market information that is very sparse.

However, the risk community can't afford to wait for the alternative rates to become more mature and widely used. The transition away from Libor is going forward, and having no plan is not an option.

The way to address the issue of insufficient market and historical data, and to select an appropriate replacement curve in these uncertain conditions, is to perform a wide-ranging sensitivity analysis. This should cover not only the yield curves themselves (e.g., their volatility, expected trend and steepness) but other respective implications on customers' behavior - including prepayments and drawing on unfunded commitments.

Lacking substantial data to perform a robust analysis of interrelations of all the above drivers of unprecedented risk, one needs to assess the potential breadth of uncertainty. The best way to simulate the potential future market environments - and to compare the alternatives efficiently - is to employ multiple forward-looking scenarios. Such scenarios should include as variables net interest income, liquidity and all available tenors of alternative replacement curves.

The current contract-by-contract approach to balance sheet management doesn't allow for the evaluation of a full range of possibilities. Through the forward-looking scenarios, in contrast, the entire balance sheet can and should be reviewed.

The top-down approach proceeds from a bank-wide perspective, starting with the aggregation of segments by lending book (e.g., corporate or consumer), loan types, market segments, funding instruments and trading book exposures. Only then is it's possible to look at all alternatives, select a few appropriate ones and use them in the bottom-up approach for additional precision.

Paths to Transition: A Plethora of Possibilities

After generating the full distribution of market environments that include all alternative reference curves, one can compare the potential replacements and their combinations. For example, such alternatives could include renewing all matured corporate loans with the SOFR; replacing all longer-term loans when such a strategy works in clients' interests on respective scenarios; and/or switching loans from floating to fixed rate.

It is important to remember that Libor is a forward-looking rate, while SOFR is backward looking. Most likely, there won't be enough time to develop the derivatives market for calibrating the full forward curve for SOFR.

The International Swaps and Derivatives Association (ISDA) suggests calculating SOFR as the compounded average of the daily SOFR over the reference period. Unlike LIBOR, which is set at the beginning of each payment period, the applicable compounded SOFR will not be determined until the end of the period. Forward-looking scenarios, however, can help estimate the range of such potential future values.

Using prespecified algorithms, a firm could potentially evaluate thousands of Libor alternatives and combined replacement strategies. It is vital for each of these alternatives to be evaluated based on the same set of full-range scenarios.

Transition plans, of course, will vary, not only according to alternative rates but also based on what products a firm wants to start with and in what order it desires to implement Libor replacements. Though there will be a myriad of choices, each replacement plan will have many outcomes, represented by both statistical expectations and the worst cases of all key indicators.

So, there are multiple dimensions of comparing possible transition plans. A few feasible alternatives can be selected algorithmically, reviewed by management and sent for the detailed analysis to legal, accounting, pricing and risk management teams.

During this transition phase, senior management should be asking themselves one question, “What are we currently doing to minimize risks and impact, and what should we be doing?” Firms must also start proactive communication and rate renegotiations (where necessary) with their customers; identify where Libor exposures offset each other; and estimate the profitability or costs associated with a replacement.

Through these actions, senior management can comply with regulations and convey to all other constituencies that no stone was left unturned in their search for the most effective and appropriate alternatives to Libor.

Alla Gil is co-founder and CEO of Straterix, which provides unique scenario tools for strategic planning and risk management. Prior to forming Straterix, Gil was the Global Head of Strategic Advisory at Goldman Sachs, Citigroup and Nomura, where she advised financial institutions and corporations on stress testing, economic capital, ALM, long-term risk projections and optimal capital allocation.