LIBOR Transition - Regulators Ramp Up The Pressure
As we move into the last nine months of transition away from sterling LIBOR, the regulators have written a ‘Dear CEO letter’ to CEOs of UK regulated firms, signed unusually by four regulatory directors - including the Governor of the Bank of England in his role as an Executive Director of the Prudential Regulation Authority (PRA).
They have also written individually to the Senior Management Function (SMF) executives at firms with the most complex LIBOR exposures, who have been nominated to be personally responsible for each firm’s oversight of the transition.
As we enter the latter stages of the transition process, their letter is clearly ramping up the pressure on UK firms and making personal accountability for the success of each firm’s transition a point of focus.
In their ‘Dear CEO letter’ the regulators stress that, now that the cessation dates for LIBOR have been confirmed, we are entering the final and critical phase of transition to Risk Free Rates (RFR). They expect all firms to meet the milestones set by the Working Group on Sterling Risk Free Reference Rates (RFRWG) and other working groups and supervisory authorities.
They set out a list of priority areas where further action is necessary to prepare for the cessation of LIBOR to ensure the safety and soundness of firms’ exposures, to ensure good client outcomes and to preserve market integrity. In summary these include:
Meeting the RFRWG End of Q1 Milestones - No incremental sterling LIBOR loan, bond, securitisation, or linear derivatives business should be written by regulated firms from 1st April unless specifically permitted within the milestones. Any non-permitted issuance after 1st April, which expires beyond end-2021, will potentially be viewed as indicative of poor risk management and poor governance of the transition.
Syndicated Lending – Transition away from LIBOR has lagged other areas of the cash markets and the regulators are concerned that some syndicate member firms may be attempting to undermine the transition. These firms should not be allowed to act as a brake on transition and Lead Arrangers should ensure that syndicate commitments entered into after 1st April do not reference LIBOR. The regulators will view any new sterling LIBOR lending commitment after 1st April as being a failing of all the banks in the syndicate.
Systems - The regulators expect all regulated firms to prioritise resources to ensure that their systems can deliver front-to-back technology solutions. Firms should ensure that systems and processes are ready to manage reliance on fall-backs post-cessation and that firms’ risk management takes full account of this reliance.
Legacy Contracts – Firms are expected to intensify their efforts to transition legacy LIBOR-linked contracts ahead of the cessation dates wherever possible. Contracts should be amended by the end of Q3 to at least include a contractually robust fall-back or an agreed conversion to a robust alternative reference rate. Where legislative solutions are not expected to support tough legacy exposures, firms should have robust plans in place to ensure LIBOR referenced exposure are addressed.
Legacy syndicated exposures – Progress in transitioning, in common with syndicated lending in general, has lagged other areas and urgent action is needed by all parties in the syndicated market. In cases where the Lead Arranger’s engagement has been insufficient member banks should now be taking their own steps to progress solutions.
Legacy Derivatives – While the ISDA fall-backs are designed to allow derivative contracts to function post-cessation, the regulators require firms to demonstrate the steps they have taken to identify where an active transition would be more appropriate and how any residual risks from relying on fall-backs would be managed. The regulators expect clients to be proactively involved in a timely manner in this process.
Conduct Risk – As transition intensifies the regulators expect firms to sharpen their efforts to traceably identify and address risks to ensure clients are treated fairly, particularly for those who are retail clients and small and medium sized enterprises. Firms must keep their clients informed about the impact of LIBOR cessation and the replacement products on offer and ensure that clients are given enough time to make informed decisions. The regulators will expect firms to demonstrate the collection and use of meaningful conduct management information and data and have in place procedures to escalate issues to senior management and the board where necessary.
Development of RFR Markets – As part of their supervisory engagement regulated firms will be expected to demonstrate the efforts they are undertaking to facilitate the transition of products from LIBOR to RFR’s.
Sterling futures and non-linear derivatives – Good progress has been made in moving most sterling swaps business away from LIBOR but there remains much to be done in the futures and options market. Firms should be building up liquidity in these products in advance of the upcoming RFRWG milestone to cease new GBP LIBOR futures and non-linear derivatives business by end-Q2 2021, unless they are for the risk management of existing positions.
Non-sterling LIBOR currencies – UK firms have significant exposures to LIBOR currencies other than sterling and slow progress in these markets is a concern. Firms should make every effort to minimise risks from exposure to all relevant LIBOR currencies. In particular, firms should ensure they cease the new use of USD LIBOR as soon as is practicable and no later than the end of 2021. Firms will be expected to demonstrate their transition progress by reference to the recommended timelines of the Alternative Reference Rates Committee (ARRC). Additionally, firms should support the transition to €STR before the discontinuation of EONIA on 3rd January 2022.
Model Changes – The PRA expects to write to firms setting out their expectations for market risk models in April and for counterparty credit risk models in June. The PRA expects all formal model change applications to be submitted by end-September 2021.
Selection of Appropriate Alternatives to LIBOR – Wherever possible firms should use the most robust alternative reference rate appropriate for the applicable product. In selecting benchmarks firms should take into account relevant industry guidelines and recommendations including the RFRWG’s use cases and the FICC Markets Standard Board’s work to establish a market standard on the use of SONIA reference rates.
In the final phase of transition, the PRA and Financial Conduct Authority (FCA) will be intensifying their supervisory focus on a firm’s management and oversight of the risks associated with transition. They will be using firms’ meetings, management information and LIBOR and RFR exposure data to assess transition progress. Further, the PRA and FCA add that they will be keeping a range of supervisory tools under review for use where they see insufficient progress, or incidents of poor risk management or governance of transition.
Peter Manning – March 2021
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