Sunsetting LIBOR: How to Avoid the Elephant Traps
The formal end of using the London Interbank Offered Rate (LIBOR) as a risk-free reference interest rate for banks and other financial institutions, in the UK at least, was scheduled for the end of 2021.
It would be reasonable to assume that this would mean it becomes part of banking history. However, in financial services the picture is less cut and dry than one would imagine. The truth about LIBOR is that it isn’t going away, instead, even after this retirement date, it will remain a key metric for many institutions for quite some time.
Part of this complex picture is a result of how regulators across the world have addressed the issue. They might have been tempted to impose a solution on their chartered banks in the past, but they recognized that the widespread use of LIBOR, in a $240tn market, across various business applications – in contracts, instrument pricing, and much else – meant that the most practical option would help the market decide what alternatives were going to be most effective.
To date, several LIBOR-alternatives are in use. In the UK, the Sterling Overnight Index Average (SONIA), which the Bank of England manages, is the preferred option. In Japan, the Tokyo Overnight Average Rate (TONA) is the alternative to Yen LIBOR. SARON, the Swiss Average Overnight Rate, is becoming the standard in Switzerland.
In the US, the picture is different. The Secured Overnight Financing Rate (SOFR) is being accepted as the alternative to US Dollar LIBOR, but the uptake has not been universal. The ‘mood music’ of US regulators remains focused on transitioning away from LIBOR. The reality is that six synthetic LIBOR fixes, administered by the Bank of England, will remain for the next 18 months to cater to those who will still use LIBOR.
The position broadly across the world is that regulators are expecting their chartered banks to cease referencing LIBOR for new loans in the coming months. In the UK, that date was January 1, 2022. The use of LIBOR will drastically reduce in the upcoming months but will not disappear entirely. This situation creates a range of issues for banks.
Added value of the global standard
The added value of LIBOR was that it was THE global standard, universally accepted by all. The situation is now more fractured, and institutions will need to ensure that everyone involved in a particular transaction understands which reference rate is being used. A reference rate may vary by country, customer, product, or instrument type.
Furthermore, regulators are now expecting that ‘new loans’ will be LIBOR-free. The issue here is, what constitutes a ‘new loan’? Does rolling a loan over without changing its LIBOR-based terms constitute a new loan? What about transactions that form part of a larger LIBOR-based contractual framework? Another issue originates when transactions are initiated outside of the main markets (US, UK, Europe or Japan). Will they remain on LIBOR or use a different reference, in which case, which one?
In short, while moving away from LIBOR eliminates some issues, it also creates significant operational risk issues for many institutions. Many of them have already invested heavily in identifying and mitigating transactions, contracts, and documentation referencing LIBOR and developing new systems and processes that highlight their preferred LIBOR-alternative. Unfortunately, the number of alternatives to LIBOR, and the continued availability of LIBOR itself, give rise to potential operational risk issues, especially long-tail risks, where exceptions remain after the formal cut-over, ready to catch the unwary.
Using spreadsheets to help capture and manage data
A standard response for busy operation teams to this type of complexity is to use spreadsheets, to help capture and manage data, without waiting for the IT function to tweak their corporate applications to help address the issue. While quick and convenient, these type of spreadsheets have a way of becoming mission-critical very quickly, whether they are used in portfolio management, financial modeling, instrument pricing, or any other application.
These spreadsheets lack change controls and the transparency found in other corporate IT applications, which means that errors and omissions can emerge without anyone realizing until it is too late. Referencing the wrong risk-free interest rate could have profound implications for a transaction or an institution’s reputation. In many ways, spreadsheets are the ideal tool for ad-hoc problems, but only if they are carefully controlled.
How can you carefully control spreadsheets?
Create a spreadsheet inventory
This gives you a foundation for centralizing the way you manage and review your critical spreadsheet estate. An inventory also acts as a repository for the essential documentation needed for defining and controlling your core spreadsheets.
Monitor to minimizes issues
Monitor critical spreadsheets proactively so that any changes made are transparent to all. This minimizes issues involving missing data, flawed calculations and formulas, or stale data.
The Discovery phase
The Discovery phase – is how companies locate mission-critical spreadsheets they need to manage data. The key here is to find the most significant spreadsheets used. These can be defined by a range of parameters, such as who uses a file, how often it is changed, what other applications and data sources it is linked to, and other relevant criteria. Clearly, user input can be included here to refine the search criteria
Mitratech offers a powerful and proven spreadsheet risk management solution that helps mitigate spreadsheet risk. Our solution is used by many of the most demanding institutions in the world. Learn more here.