The London Interbank Offer Rate, or LIBOR, which according to the New York Times is the “one number that arguably matters more than any other” in the world of finance, will no longer be the primary benchmark rate used by the financial services industry as of year-end 2021. In the 35 years since the financial markets began using LIBOR, firms across the financial services industry, including commercial banks, investment banks, asset managers, insurers and retail lenders, have used LIBOR as the interest rate benchmark to price or value bonds, securitizations, derivatives and a wide variety of loans.
The plan to replace LIBOR is attributable to significant market conduct failures – notably, self-serving market-manipulation schemes in which some banks allegedly provided inaccurate information about their borrowing rates to make themselves appear less risky during the financial crisis. In certain cases, some banks, on their own or in collusion with other institutions, provided rate information that allowed them to book substantial profits. As a result of these actions, there were winners and losers among financial institution customers (e.g., borrowers may have benefited, while investors may have received lower returns) and market confidence in LIBOR was eroded.
These schemes began to unravel in 2008 when the Wall Street Journal published an article questioning the integrity of LIBOR. Skepticism about the rate-setting process prompted government investigations that eventually confirmed the market wrongdoing and led to billions of dollars in penalties for the banks involved and jail terms for some former traders. Among governments and regulatory bodies in several major financial jurisdictions, a consensus view emerged that LIBOR needed to be replaced.
The UK Financial Conduct Authority (FCA) reached a decision to phase out LIBOR in July 2017 after significant consultation with panel banks. Over the last year, the regulators globally have been voicing concerns about the financial industry’s preparedness to replace LIBOR with suitable alternative rates. In the last weeks of 2019, U.S. regulators signaled their interest in the progress being made, with the Federal Reserve and the Office of the Comptroller of the Currency both advising the institutions they supervise that their examiners will be checking progress during the examination process, and the New York Department of Financial Services directing the state’s regulated financial institutions to submit a LIBOR transition plan by February 7, 2020.
The challenges associated with transition are many, including market acceptance of alternative replacement rates, legal and contractual risks associated with current contracts, the magnitude of the operational implementation, risk management and valuation implications, and required systems and data changes. Over the last year, regulators globally have been voicing apprehension about the financial services industry’s preparedness to replace LIBOR with suitable alternative rates. To avoid another market scandal and maintain the integrity of replacement rates, the FCA and the UK Prudential Regulation Authority (PRA) are also advising the institutions they supervise that one of their overarching concerns with the LIBOR migration – a concern that is undoubtedly shared by other regulators – is conduct risk: the risk that any action taken by a bank or other financial institution could result in poor outcomes for customers or negatively impact market stability.
Leveraging the guidance provided by the UK regulators (most recently in the FCA’s “Conduct Risk During LIBOR Transition: Questions and Answers” document, first published on November 19, 2019), the Association for Financial Markets in Europe (AFME), in conjunction with international law firm Simmons & Simmons, has developed a framework for managing the conduct and compliance risks of the LIBOR transition. The framework covers three stages of LIBOR transition: project planning, project implementation and post-implementation. At each stage, financial institutions are presented with a series of critical questions to consider. While the framework includes many basic expectations for large-scale project management, it also incorporates steps for ensuring that institutions address the conduct risk concerns regulators have expressed.
Stage 1: Project Planning
In the first stage, financial institutions are reminded of the importance of project planning when undertaking a large-scale legal and regulatory change project, such as the LIBOR transition. Specific focus is afforded to the appointment of responsible parties, briefing and role of senior managers, the development of a robust and flexible project governance structure, the management of industry and regulator engagement, and the establishment of an effective record-keeping process. Some of the questions posed in this stage include:
- Which Senior Managers (in the UK, likely individuals subject to the Senior Managers and Certification Regime) will be given responsibility for LIBOR transition for each business area and overall?
- How are Senior Managers briefed to ensure they understand the risks of transition?
- Do Senior Managers have sufficient financial and non-financial resources available to them to carry out their role effectively?
- What committee structure and constitution is required in order to ensure appropriate coverage of each business area affected by the LIBOR transition?
- How can the firm demonstrate that conduct issues such as information sharing (both internally and externally) and conflicts of interest are considered within the LIBOR transition governance structure, including in committees, as relevant?
- What processes and controls are in place to record the identification, management, monitoring and reporting of risks to a firm’s business?
As it relates to conduct risk, the framework specifically notes the FCA’s view in its Q&A document that “Firms are more likely to be able to demonstrate that they have fulfilled their duty to treat customers fairly where they adopt a replacement rate that aligns with established market consensus.” The framework recommends asking a number of questions pertaining to the nature of expected engagement and the evidence thereof, including the following:
- What steps need to be taken to set up an effective process to update the relevant regulators in relation to the firm’s LIBOR transition process?
- In which industry groups does the firm participate, through attendance and active roles? What process is in place to record the firm’s participation?
Stage 2: Project Implementation
In Stage 2, the framework emphasizes project governance, treating customers fairly, client communications, conflicts of interest and market abuses, outsourcing and training. Financial institutions should consider the following questions during this stage:
- What process is in place, or might need to be implemented, in order to consider the impact of LIBOR transition on existing and new instruments?
- What process is in place for conducting an assessment of the consequences of LIBOR transition in relation to affected clients and corresponding contracts and identifying transition options?
- What team(s) oversee communication strategies in relation to each impacted client area?
- How will firms engage with client queries and complaints?
- What process is in place to: (i) identify potential conflicts of interest that may arise as a result of, or during, LIBOR transition; (ii) determine corresponding risk mitigants; and (iii) monitor the implementation of those mitigants?
- What training is provided to staff on conflicts of interest and market abuse requirements in the context of LIBOR transition?
- What training is required to mitigate conduct risks?
- Does the firm have any existing outsourced, insourced or delegated functions that might be impacted by LIBOR transition? If yes, is the outsourced/insourced service provider or delegee taking appropriate steps to manage LIBOR transition – can the firm evidence appropriate oversight of that function?
Stage 3: Post-implementation
In the third and final stage of the framework, firms are reminded that conduct risks associated with LIBOR transition continue post-implementation. Firms are encouraged to ask a series of questions relating to their ongoing monitoring efforts, such as:
- Who will be responsible for monitoring client impact and engagement?
- How will the firm ensure consistency in the treatment of different client types and, within those groups, clients?
- Does the firm have an effective surveillance process to prevent, manage and mitigate the potential conduct risks arising out of the firm’s LIBOR transition project?
- Does the firm have a process in place for determining if and when the LIBOR transition process has been unsuccessful in certain areas?
The questions included above are but a sample of those suggested by the AFME framework. What is clear even from this excerpt is that a well-developed and documented plan that covers the life cycle of transition – planning, execution and post-implementation – is critical to success and to convincing the regulators and the market that there is integrity to the LIBOR replacement rates.
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