Despite the challenges posed by the current pandemic and economic crisis, regulators remain committed to transitioning from the London Interbank Offered Rate (LIBOR) and other benchmarks to alternative risk-free reference rates by the end of 2021. Close collaboration among multiple stakeholders is crucial to the success of this complex, wide-ranging initiative.

S&P Global Ratings believes European banks, particularly large groups, are well equipped to handle the transition, since they have a deep pool of skilled staff and the experience of managing such large change projects. They will need to use all the resources at their disposal to address a wide array of risks, ranging from operational, commercial, and financial to legal, reputation, compliance, accounting, and prudential. Banks' vulnerability to transition risks will depend more on their respective business profiles and geographic spread rather than on the country of domicile or jurisdiction.

Benchmark Reform: How We Got Here

Interbank borrowing and the pricing of many financial instruments depend on having reliable benchmarks. The aim of the reform, as envisioned in the EU's 2016 benchmark regulation (BMR), is to replace existing benchmarks with others that better reflect liquid market pricing and actual transactions, but are not subject to market-makers' judgement. This initiative follows what the regulation cites as "serious cases of manipulation of interest rate benchmarks such as LIBOR and EURIBOR" dating back over a decade. The current benchmarks can be subject to conflicts of interest, and the use of discretion alongside weak governance regimes increases their vulnerability to errors and manipulation.

Transitioning from these benchmarks (see table 1) is an ambitious undertaking, however. The process involves various complementary roles and contributors, and relies on effort sharing. Also, the replacement benchmarks will be used as reference rates in a large number of cash and derivative transactions. Therefore, their implementation will affect a wide range of businesses and instruments, as well as all parties to financial contracts.

Table 1

Banks Face A Multi-Faceted Challenge

In 2021, banks have to line up new products with specific fallback language and based on the replacement benchmarks.   The fallback language in new and revised contracts must comply with the requirements of the BMR, which took effect in 2018, and follow the practice and standards that will be commonly used in the market by 2022. Banks also need to design new products that reference the replacement benchmarks' definitions and correspond to the new forward-looking term rates. These new term rates are not yet published in all jurisdictions, however. For instance, in the U.S., the forward-looking term secured overnight financing rate (SOFR) is expected in the first half of 2021.

Banks also need to identify and manage all existing instruments using benchmarks that will be replaced and possibly discontinued.   This exercise can lead to disputes with counterparties stemming from the potential value transfer that interest settlements and valuations using replacement benchmarks can generate after Jan. 1, 2022. The European Central Bank (ECB) has already provided for a one-off spread of 8.5 basis points (bps) applicable to the transition to €STR (euro short-term rate) from EONIA (euro overnight index average). However, conditions are yet to be set for other benchmarks. The transition process also calls for converting existing fallback conditions (repapering) in advance, if not replacing the instruments with new ones. Banks face a limited timeframe to contact counterparties and obtain consent to revise or replace legacy contracts that lack fallback provisions.

The contractual terms of some instruments represent a so-called "tough legacy," since achieving their conversion may be quite complex.   In these cases, banks need to closely manage the technical and legal aspects of discontinuing LIBOR, their relationships with counterparties, and compliance with rules of commercial conduct. We bear in mind that, to do so, banks must have sufficient visibility on the conditions of discontinuation and the likelihood of possible scenarios. To help clarify this area of uncertainty, the U.K. government announced in June its intention to propose a law enhancing the powers of the Financial Conduct Authority (FCA). This provides a means for reducing disruption risk related to the transition, chiefly in case of the discontinuation of a benchmark. We believe the FCA may subsequently introduce a synthetic LIBOR (notably including a credit spread based on market consensus) that could be used for tough legacy contracts. Similarly, on July 24, 2020, the European Commission proposed amending EU rules to further empower benchmark regulators, and so limit possible disruption that can erode the integrity and stability of financial markets. To address the problem of tough legacy in New York law contracts, the Federal Reserve Bank's Alternative Reference Rates Committee (ARRC) has proposed substituting LIBOR with the recommended new benchmark, and so override contracts. We will monitor developments in that area.

Market participants need to cope with possible shortcomings of the alternative benchmarks.  These include potential gaps in the financial market infrastructure, lack of a track record and liquidity for certain new benchmarks, as well as the need for compound interest rate curves and reliable forward-looking term rates. For the U.K.'s new benchmark SONIA (Sterling Overnight Index Average), the Bank of England (BOE) has already published a compound index, and a provisional term rate is expected by the end of 2020. This calls for significant adaptations encompassing trading and back-office IT tools, and calculation models factoring in new interest rate curves. Financial institutions and counterparties also need to train employees and implement policies to prevent misconduct. With regard to market risk, basis risk can arise upon replacement of a benchmark and lead to valuation differences where products include references to different conventions, in particular, combining cash and derivatives.

All in all, hurdles for banks during the transition process (see table 2) relate notably to having to rely on operational capacities (human and data management resources) to implement changes and adapt the management of internal transaction flows and market risk. But banks also need to reengineer their product offerings and distribution, as well as tailor commercial care and external communication to all counterparties.

Table 2

The Complexity For Banks Varies By Business And Geographic Focus

In our view, the level of complexity will depend more on each bank or banking group's business profile than on the country of domicile. For instance, it will reflect the exposure type--notably whether predominantly from corporate and investment banking--as well as the range of countries or regions the bank operates in. The latter can imply managing the transition in several different jurisdictions, where some regulators are more advanced than others in setting deadlines for using the new benchmarks. The pace of transition can therefore differ from one country to the other, subject to input from the relevant working groups and the degree of monitoring by supervisory authorities.

We expect the transition will be less complex for syndicated deals and transactions cleared through market infrastructures, since these will benefit from collective management. This should also be the case for derivatives negotiated on a bilateral basis but contracted under the International Swap and Derivatives Association's (ISDA's) master agreements. We believe most market participants will likely adhere to ISDA's announced protocol, which is scheduled to take effect in January 2021. Conversely, banks carrying a large amount of complex instruments could face substantial difficulty in adapting fallback language or minimizing value transfers. Bilateral transactions that don't conform to standard master agreements could also complicate the changeover, although we expect the number of such deals to be manageable.

Successful Execution Hinges On Supervision And Market Participants' Commitment

We see several factors supporting the likelihood of the transition being completed in a timely manner, notably for the frontrunner, the U.K.:

• Consistent messaging and active monitoring by the authorities. For instance, the BOE has recommended that banks determine a product offer based on replacement benchmarks by Sept. 30, 2020; U.K. banks have already started offering SONIA-based loans.
• Initiatives to facilitate standardization and market convergence to new fallback definitions. The Sterling Risk-Free-Rate Working Group was established in 2015, and had already completed its market consultation by the second half of 2018 to develop a forward-looking SONIA term rate.

In all jurisdictions, frameworks are progressively being put in place to organize the production and publication of replacement benchmarks. In the U.S., the ARCC has defined a roadmap, notably through milestones for the expected commercial switch to new products. In the E.U., the ECB and the working group on euro risk free rates have been actively involved in defining the replacement benchmark. Moreover, potential legislative actions to support an orderly transition could ease the convergence and adoption of fallback standards.

Postponement Doesn't Appear To Be On The Cards

While the pandemic may have delayed the transition process for many market participants, there is no strong signal that the implementation date will be put off. The FCA, BOE, and Sterling Risk-Free Reference Rates Working Group stated on March 25, 2020, that the central assumption that firms cannot rely on LIBOR being published after 2021 has not changed. Jan. 1, 2022, remains the target implementation date for all firms. Also, in July 2020, the BOE's governor reiterated that he did not expect to see new sterling LIBOR-linked lending after March 31, 2021.

However, sticking to the implementation deadline depends on the coordination of multiple contributors, including banks (not only those on benchmark panels), customers, investors, market-infrastructure providers, international organizations, working groups, and the authorities. Furthermore, the transition process involves participants active in several systems and markets, and applies to numerous currencies.

We are mindful of the intricacy of discussions needed to achieve a successful transition, and of the relatively short time left to do so. We note that the ISDA announced on Sept. 23, 2020, that the target effective date for its fallback protocol won't be before January 2021.

Milestones Are Clear But Progress Is Not

The collaborative nature of the transition process should allow for generally accepted fallback language and standardized use of the new interest rates. Yet this approach can also leave the market with two or more competing solutions, rather than one common standard. However, we believe all market participants are committed to reaching a consensus. We consider that agreement will benefit from active regulatory supervision, guidance from the respective working groups, and, by design, entrenchment of the process in the market. Consequently, although a detailed schedule is not in place, we think the outline of the transition and supporting road map allow piloting and control of the process (see charts 1, 2, and 3) based on strict enforcement of key milestones.

That said, coordination and control to ensure overall timeliness is not an easy task. For example, a bank would need to know--in advance--the fallback language and term-interest-rate definition that market participants will ultimately agree on, before it can design and sell new products that meet customers' needs. This shows why all parties have to move in tandem. This complex situation is particularly relevant for the huge U.S. dollar market, where uptake of products linked to the SOFR is slow.

Chart 1

Chart 2

Chart 3

Banks' Preparedness And Technical Capability Ease Concerns

Generally, banks have set up task forces and have been actively preparing for the LIBOR transition over the past 18 months, and in some cases even longer. This is because financial market supervisors and authorities have been monitoring the transition since its early stages. The BMR was passed in the E.U. in 2016 and has been applicable since Jan. 1, 2018. Still, the transition process is an additional strain on banks' resources. This is owing to the numerous adaptations needed, for instance to meet regulatory and compliance requirements, and, in particular for U.K. banks, to cope with the country's exit from the EU.

Considering the variety of market segments and instruments, implementation will be cumbersome. But, overall, we believe the majority of instruments will allow for straight-forward adaptation of the fallback language and replacement rates. Despite the operational complexity of reviewing transactions within large portfolios, we see limited risks, since we believe most large banks have the capacity and expertise required to shift to the new fallback language and interest rate benchmarks.

For smaller banks and those operating in emerging markets, we foresee a more reactive approach to the transition, spurred in some cases by regulators. For many of them, contracts tied to LIBOR comprise a small part of banks' portfolio, and often mature before 2022. For instance, Croatia abolished its ZIBOR (Zagreb Interbank Offered Rate) on Dec. 31, 2019, since there was little appetite to align it with the BMR's requirements. The discontinuation had no negative effect on the market according to the regulator, since ZIBOR was used for only 1.3% of loans. In Turkey, the reference rates TRLIBOR and TRLIBID will be replaced by the TLREF (Turkish Lira Overnight Reference Rate), which the Istanbul Stock Exchange started publishing on June 17, 2019. We understand the TLREF is referenced in securities issued by the Ministry of Treasury and Finance.

Communication Will Remain Key

Although an orderly and timely rollout of the benchmark rate reform is not guaranteed, we do not think the overall process will disrupt banking systems. We consider that the collaborative approach for the transition fosters open communication and knowledge sharing, which should aid timeliness, and we anticipate that banks will be ready to offer the new products on time. Although discussions regarding certain legacy transactions may well drag into 2022, the consequences would be moderate if there's a small number of such transactions. That said, the conversion of transactions is subject to several moving parts, including counterparties' disposition, so the possibility of a bank missing an important milestone cannot be ruled out.

Beyond technical complexities, we see limited critical risks stemming from tough legacy instruments. We foresee the need for negotiation in some cases, however, in particular if disputes regarding value transfer arise. At this stage, we are not aware of large exposures maturing after 2021 that banks would not be able to renegotiate or replace, although this depends on the counterparties' willingness to reach an agreement.

Nevertheless, banks have to engage with customers and obtain consent from counterparties on various types of contracts, which can be problematic, especially since the fallback language and some of the newly defined forward-looking term rates are still under discussion. Moreover, not all corporate borrowers are fully acquainted with the benchmark transition process, which entails legal and conduct risks. Transparency and effective communication from all stakeholders, including industry bodies and trade associations, are therefore critical to success.

Related Research

• Credit FAQ: How To Say Goodbye To LIBOR Without Creating Market Chaos, Sept. 23, 2019
• Credit FAQ: SONIA As An Alternative To LIBOR In U.K. Structured Finance Transactions, Feb. 6, 2019