The IBOR transition is one of the issues currently dominating the financial world. The change in benchmark rates, which will take effect on 1 January 2022, involves many adjustments. But what precisely will change? What do banks and other financial institutions need to do to prepare for the change? And what role is played by supervisory directors?
Eva Dieben is a Financial Services partner at BDO Legal. She has held a variety of positions in the banking and insurance world, and has worked for organisations that include SNS Reaal, Aegon N.V. , a.s.r. and the Dutch Banking Association. In this article she discusses the IBOR transition and explains what supervisory directors of financial institutions need to know.
The role of IBORs within the financial sector
What exactly is meant by ‘the IBOR transition’? “IBORs are interbank offered rates and form a set of interest rate benchmarks,” Ms Dieben said. “They are interest rates that are used for short-term interbank loans. The most commonly used IBOR is EURIBOR - the European Interbank Offered Rate - and another well-known IBOR is LIBOR - the London Interbank Offered Rate. These IBORs have been used as reference interest rates for financial transactions, such as interest rate swaps, bonds and business loans, for more than 30 years.”
IBORs are clearly essential for the financial sector. “Within the financial sector, the benchmark rates are used in models, for example in pricing models and risk models. IBORs have an impact on valuations, hedging strategies, sensitivity analyses and risk systems used in the sector. Besides being used by banks, IBORs are also used by other financial institutions that develop and offer products linked to an IBOR, such as investment funds and insurance companies. They are also used to determine mortgage interest rates. This is why the IBOR transition is regarded as one of the greatest revolutions in the financial sector since the financial crisis. I think there will be big problems if it is not handled properly,” Ms Dieben said.
Background to the transition: the LIBOR scandal and the aftermath of the financial crisis
The transition to new benchmark rates was prompted to a significant extent by the LIBOR scandal, which came to light in 2012. “The LIBOR scandal showed that the benchmark rates were vulnerable to manipulation because they were determined using a method based on a survey of banks,” Ms Dieben said. “Rather than being determined using objectively measurable interest rates based on actual transactions, the benchmark rates were fixed by agreement, based on expectations and prospects. This paved the way for manipulation, when some of the people working for banks on the panels falsely inflated the expected interbank rates they submitted. The traders at those banks then benefited from this by trading investments to make profits.”
Besides the LIBOR scandal, there was another reason for reforming the system of benchmark rates: it was simply no longer sufficiently relevant. “Since the financial crisis there has been a fall in the number of interbank money market transactions, which formed the basis for determining the interest rate benchmarks,” Ms Dieben explained. “This is why the IBORs we are familiar with are no longer representative of the market on which those benchmarks are based. This is a direct consequence of the financial crisis that followed the collapse of Lehman Brothers in 2008, and the European sovereign debt crisis. All kinds of new legislation has been introduced since then, mostly with the aim of ensuring banks strengthen their balance sheets by increasing their capital buffers. This has resulted in a steep decline in demand from banks for short-term funding. Moreover, the fall in the number of interbank money market transactions has been reinforced by central banks around the world, which have bought up bonds, granted cheaper loans to banks and introduced negative interest rates.”
Increased regulation to ensure reliable benchmarks
What does the IBOR transition entail exactly, and what specifically are the changes? “There has been an increase in regulation relating to benchmark transparency, including the introduction of the Benchmark Regulation in Europe. The aim of this regulation is to ensure that the benchmarks are reliable and robust, and to minimise any conflicts of interest that may arise when determining the benchmark. Market players can play various roles in the context of a benchmark, and rules have been introduced for each role. For example, benchmark administrators have to apply to the AFM (Netherlands Authority for the Financial Markets) for authorisation. With effect from 2018, users, such as banks and insurance companies, have been required to have an action plan that sets out what they will do if a benchmark they use ceases to be provided. The AFM also oversees the drafting of such plans.”
Financial institutions have to do a great deal of work in order to prepare for the IBOR transition. “It has an impact on contracts, systems and models,” Ms Dieben said. “Contacts need to be renegotiated and may also need to be amended to include fall-back provisions that allow a benchmark to be replaced if it is modified or ceases to be provided. Calculation models and IT systems also need to be adjusted. Many financial institutions have therefore launched major projects to perform impact analyses and implement legal, functional and technical changes, among other things.
What complicates matters, however, is the fact that there is still a great deal of uncertainty regarding the timing of the transition. This is because a number of different scenarios are possible in practice. For instance, the transition may take place at a fixed moment in time. This is anticipated in the legislation (transition date of 1 January 2022). If market participants decide not to wait for the statutory transition date and instead proactively move to the new reference rates at an earlier date, the transition may also take place before the statutory transition date; in this case the market will force the transition by itself because all the liquidity in contracts linked to IBORs will ‘disappear’.”
What specifically could go wrong if a financial institution fails to make proper arrangements in time? “The funding ratios of pension funds, for example, are related to interest curves, which in turn are partly based on the IBORs. The new IBORs are priced in a different way from existing benchmarks, and their impact on long-term liabilities is also different. Pension funds, for example, will need to make sure the transition is handled properly so that their funding ratios do not plummet,” Ms Dieben explained.
Prevent that supervisory directors have to act as crisis managers
What does Ms Dieben think what all of this means for the supervisory directors of financial institutions? “I think what matters most is that supervisory directors are aware that this is happening and ascertain that the organisation and the management board are making the issue a priority. If they are not, the supervisory directors will need to play a more active role, for example by stating what the implications will be if the transition is not properly prepared and something goes wrong. In any event, supervisory directors will need to ask to see the action plan in order to assess whether there is a focus on the implementation of the benchmark rate reform, how the matter is being dealt with, and whether responsibility for this matter has been properly assigned within the organisation's main bodies. It also seems obvious that the issue should be discussed in more detail by the Supervisory Board's audit committee or risk committee.
Should anything go wrong, the supervisory directors will - in my opinion - become something akin to crisis managers. In that situation, they will have to become more involved with the organisation in order to arrive at a solution in very close consultation with the management board and the relevant supervisor. The moment that the solvency ratios of banks and insurance companies, and the funding ratios of pension funds, come under pressure, it will be necessary to draw up recovery plans, and I can imagine that supervisory directors will be closely involved in this process, depending on the size of the organisation.”
It is not yet certain that this will be necessary, as a report published by the AFN and DNB in 2019 found that financial institutions are generally aware of the scale of the IBOR transition and the impact it will have. The best thing that financial institutions can do is to continue to make every effort in this area in the coming months, and supervisory directors will certainly need to monitor matters closely in order to avoid having to act as crisis managers.
Please do not hesitate to contact Eva Dieben at BDO Legal if you have any questions about this article or require more information. Just send an email to [email protected] or call +31 (0)6 41 20 20 37.