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Benchmark Regulation: challenges and impacts for Asset-Liability Management

The LIBOR scandal, and IBOR rates in general, highlighted interbank rate manipulation; the fix was based on rate declaration by a panel of banks. This article presents the possible outcomes.

The LIBOR Scandal

In 2012, the LIBOR scandal, and IBOR rates in general, highlighted interbank rate manipulation. The fixing mechanism was based on rate declaration by a panel of banks. In order to mitigate the risks associated with such a mechanism, and to be able to obtain reliable benchmarks, many projects were undertaken within financial entities (Federal Reserve System, European Central Bank, Bank of England, Bank of Japan and SIX Swiss Exchange).

In this context, this article presents the possible outcomes such as Risk Free Rates (RFRs) set up and the associated timing. Beyond these evolutions, we will focus on Asset-Liability Management impacts for financial institutions, in charge of interest rates risk management, consequently affected by the benchmarks transition.

Possible alternatives

Alternative solutions that banks are considering could be presented as follows: RFRs (specific for each currency) are overnight rates based on transaction analyses following different criteria according to the specific benchmark. Apart from SARON and SOFR, those RFRs (SONIA, TONAR and €STR) are “unsecured” rates, meaning that they are based on uncollateralized borrowing rates. EONIA will be replaced by €STR and gradual adoption could be based on the new benchmark plus a spread adjustment compared to EONIA value. As regards EURIBOR, new calculation methodology will be submitted to the FSMA (Financial Services and Market Authority in Belgium) in Q2 2019 in order to obtain a validation for the end of 2019. EURIBOR would be based on 3 contribution levels: the first one based on real transactions, second one derived from extrapolation from real data, and the third one relying on current methodology but with higher traceability. If this methodology is not validated by the FSMA, capitalized €STR would probably be used in contractual clauses for new contracts referencing EURIBOR. Moreover, as many European banks asked for, the transition period has been extended for 2 years until 1 st January 2022.

Impacts for Asset-Liability Management: a complex modelling of forward rates

One of the first impacts is linked to financial instruments modelling. In order to make management decisions (swaps buying to cover interest rates positions for instance), Asset-Liability Management of financial institutions needs to provide expected interests and capital cash flows until balance-sheet run-off. This will allow the production of steering indicators. Many balance-sheet (credits…) and off balance-sheet (interest rates swaps…) items are based on IBOR indexation and could be modified after the end of the “traditional” versions of IBOR. Therefore, indicator production based on reliable rates, characteristics, and rates evolution scenarios remain complex and uncertain.

Models and limits redefinition

Besides, if we consider an evolution scenario for which RFRs (overnight rates) would be more used than former IBOR, spreads between those IBOR and RFRs and volatility would be one important issue. In case of interest rate shocks, RFRs could be more volatile whatever the currency used. This could lead to a very time-consuming job of reviewing shock scenarios for several sensitivity calculations and potentially reconsidering limits system linked to those sensitivity indicators.

Taking into account the delay setting up new benchmarks

Another risk is that not all products switch at the same time. This could make interest rate gaps more complex and represent an important challenge for Asset-Liability Management. Indeed, it would be necessary to handle hedging strategies in the best possible way and not to impact interests margin in case of positive rates shift among benchmarks.

Heavy transversal impacts

Benchmark reform is a strategic topic for financial institutions and it is essential to assess the impacts of this reform before the deadline of the end of 2021. Beyond the impacts already mentioned, this reform will have operational impacts (IT systems, business procedures, indicators calculation impacts, new controls and limits set up,…), product management (new indexations launches, legal contracts,..), accounting (recognition / unrecognition of some products), valuation and risks (valuation curves, basis risk, hedging,…). Financial institutions together with their ALM departments still have a long way to go.

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