FSB Report: Supervisory issues associated with benchmark transition: major LIBOR transition risks

This article was originally posted on Banking Litigation Notes.

The Financial Stability Board (FSB) has published its long-awaited report to the G20 on supervisory issues related to LIBOR transition. It follows a survey of the state of preparedness of regulators around the globe and presents its recommendations. The purpose of this engagement is to facilitate greater coordination on a global level, to mitigate the impact on financial stability generally and both financial institutions and non-financial institutions specifically: FSB Report: Supervisory issues associated with benchmark transition.

Results of survey on preparedness of global regulators

The results of the questionnaire on supervisory issues strikingly, but unsurprisingly, reveal a wide range across different jurisdictions’ levels of preparedness for LIBOR transition in advance of the expected transition date of end-2021. While some differences in approach and timeline between jurisdictions are to be expected, the report is critical of the differing timelines and supervisory expectations for transition across jurisdictions:

“Jurisdiction by jurisdiction differences in approach and timeline are unavoidable. However, to avoid the greater risk of being unprepared by the end of 2021, there should be no excuses for a ‘race to the bottom’ to move at the pace of the slowest.”

For example, very few jurisdictions have dedicated roll-off timelines or targets to industry, and, where timelines are in place, monitoring is complicated by the varying timelines for different products. The report recommends that authorities in each impacted jurisdiction establish a formal LIBOR transition strategy, which may include interacting with national working groups with a view to set out milestones and a transition roadmap with clearly specified actions that market participants should take. The report also suggests increased international cooperation as a means of mitigating the inconsistency in transition timing and approaches by sharing information on best practices and challenges.

In light of the survey’s conclusion that a considerable portion of financial institutions across jurisdictions are yet to start or are still in the planning stages of their transition, the FSB has highlighted a need to step up the coordination and monitoring effort at an international level. It has accordingly identified a number of areas for strengthened supervisory actions in order to facilitate efforts by individual institutions to progress their transition programmes.

Major LIBOR transition risks identified by the FSB

The FSB has also provided a useful summary of some of the major LIBOR transition risks for financial institutions, which will be very familiar to those who have been following the developments on this topic over the last few years, and which we explained in more detail in our previous article on the risks (LIBOR is being overtaken: Will it be a car crash? (2019) 34 J.I.B.L.R.):

• Operational/systems risks – Systems and processes must be updated for all products currently referencing LIBOR so that they can instead rely on alternative reference rates and calculate and manage any fallback adjustments in order to prevent any operational disruptions.
• Legal risks – Contract frustration and counterparty litigation are key areas of concern if institutions do not adequately identify and address affected legacy contracts, especially with regard to cash market products and long-dated contracts. The risks could be compounded by the volume and complexity of potential contract amendments and potential consent required for covenant modifications.
• Prudential risks – Institutions may find difficulties in managing market risks and calculating embedded gains or losses for margin requirements, and experience a range of capital impact issues in case pricing and valuation inaccuracies arise. Where interest rate models need to be developed and approved, institutions may face capacity constraints or a lack of historical data.
• Conduct, litigation and reputational risks – The report notes risks around conduct risk identification and management, especially with regard to the fair treatment of clients, potential conflicts of interests, mis-selling and misconduct, which could lead to potential class-action litigation.
• Hedging risks – Different parts of hedged positions may transition at different times or to different fallback rates, leaving institutions exposed to new basis risks. Market participants may also face increased hedging costs if liquidity remains low in the alternative RFRs.
• Accounting risks – If work to reform national and international accounting standards is not adequate or completed on time, there may be unintended impacts on accounting (e.g. with respect to hedging or profitability) or taxation.
• Others – Financial institutions face difficulties in communicating transition-related issues with clients (finding the right informational level, etc.) and in pricing instruments (particularly in the early stages of transition when liquidity in new instruments is low). Further, financial institutions and non-financial institutions face potential resource constraints.