Challenges for banks

LIBOR contracts may vex banks with benchmark retirement looming

 

This analysis is by Bloomberg Intelligence Senior Analyst Sarah Jane Mahmud. It appeared first on the Bloomberg Terminal.

Banks may need to invest significant sums to bolster their regulatory risk operations or face heightened legal scrutiny, given the volume of contracts still referencing the LIBOR benchmark that’s due to retire at the end of 2021 (and June 30, 2023 for dollar-denominated LIBOR). Large-scale contract remediation and credit-adjustment spread calculations take time, which is in too short supply.

USD LIBOR maturing from July 1, 2023 by debt type

Source: Bloomberg

The Pandora’s box problem with fallbacks

As banks transition from LIBOR, it’s our view that fallback provisions — contract clauses providing for a move to an alternative rate if LIBOR is no longer viable — may do more harm than good. Fallbacks are designed to cover only a short-term lapse in LIBOR, not its permanent end, giving rise to unintended results that could dramatically change a product (e.g., convert floating-rate to fixed), leaving banks vulnerable to litigation. Moreover, about 40 million contracts are estimated to contain no fallback language at all, according to Factor Law, leaving contract renegotiation the only practical solution. But time is tight.

In our view, standardized fallback language developed by ISDA for derivatives contracts (most interest rate swaps and options) is a positive step, offering banks certainty.

Secured Overnight Financing Rate swap curve

Source: Bloomberg

Contract remediation is operational nightmare

Banks may struggle to quantify their LIBOR exposures without significant investment in data-management technology, we believe, adding to cost pressure. The scale of the challenge in just eight months (26 months for USD LIBOR) is huge — banks must identify, classify and extract data from thousands of contracts, which may then need to be amended or renegotiated with a replacement rate. Transition costs among the world’s largest 14 banks could even top $1.2 billion, according to an Oliver Wyman report, with the bulk tied to contract repapering.

Deutsche Bank, among others, noted on earnings calls that uncertainty linked to the discontinuation of LIBOR and transition to risk-free rates may have an adverse effect on operations and profitability.

Poor liquidity may hamper spread adjustments

As no alternative rate is a like-for-like LIBOR replacement, banks will need to make an adjustment for credit and term differences between the two in order to avoid a value transfer and minimize legal risk. Yet, success depends on there being a deep, liquid market in the successor rate, otherwise valuation discrepancies arise. As more market participants use overnight risk-free rates, liquidity will deepen and spreads will better reflect underlying market transactions.

Credit Suisse was the first bank to issue debt linked to the Secured Overnight Financing Rate (SOFR), USD LIBOR’s preferred alternative. Some 906 SOFR-linked bonds were issued in 2020, and 391 in 1Q21. JPMorgan, Bank of America, Barclays, Wells Fargo, BMO, RBC, Citigroup and Goldman Sachs top the Bloomberg manager league table with a 56% market share.

 

Bloomberg’s index compounding calculator

Source: Bloomberg

LIBOR to RFR isn’t a straightforward switch

RFRs such as SOFR, SONIA (Sterling Overnight Interbank Average Rate) and ESTR (Euro Short-Term Rate) are structurally different to LIBOR, which is what makes the transition tricky. LIBOR is forward-looking, quoted for five currencies across seven tenors and with the linked interest-rate payable known at the start of the interest period. RFRs are overnight rates published the next day. A three-month rate, for example, can’t be calculated in the same way. LIBOR also builds in credit risk, as it represents the average cost of bank borrowing — this isn’t incorporated into an RFR.

Nine ESTR-linked bonds and 106,980 loans are in issue, according to Bloomberg data, with Credit Agricole, Deutsche Bank, Standard Chartered Bank and UniCredit topping the Bloomberg manager league table, in that order, with equal 25% market share.

Bloomberg SOFR league table

Source: Bloomberg