UK authorities (BoE, PRA, and FCA) recently published updates on LIBOR reforms, including the PRA and FCA joint letter on the final phase of transition from LIBOR to risk-free rates. The letter highlights that all firms are expected to meet the milestones of the Working Group on Sterling Risk Free Reference Rates as well as the targets of other working groups and relevant supervisory authorities, as appropriate. The annex to the letter sets out a list of priority areas where further action is needed from firms to prepare for the cessation of LIBOR. The priority areas cover the cessation of new sterling LIBOR business milestones, cessation of new LIBOR-referencing syndicated lending, systems readiness for LIBOR cessation, active transition of legacy LIBOR exposures, conduct risk mitigation, development of risk-free rate markets, changes in internal credit and market risk models, and selection of appropriate alternatives to LIBOR.
During the final phase of LIBOR transition, PRA and FCA are intensifying supervisory focus on firms’ management and oversight of the risks associated with transition. PRA and FCA will use firm meetings, relevant management information, and the LIBOR and risk-free rate exposure data to assess the transition progress of firms. The letter addresses the following key expectations for the preparation of LIBOR cessation:
- Any incident of sterling LIBOR referencing loan, bond, or securitization issuance from April 01, 2021 onward that expires beyond the end of 2021 would potentially be viewed as indicative of poor risk management and poor governance of transition.
- So far, progress in transitioning new sterling syndicated lending business away from LIBOR has lagged. The Lead Arranger(s) should take the principal role in ensuring that all syndicate commitments entered into after April 01, 2021 do not reference sterling LIBOR. Syndicate members that are not ready or willing to commit on alternative rates from April 1 onward should not be included in that syndicate. Any new sterling LIBOR syndicated lending commitment after the end-Q1 milestone would be viewed as a collective failing of all the banks in the syndicate.
- Firms are expected to prioritize resources to expedite the delivery of strategic front-to-back technology solutions for risk-free rates to the greatest extent possible. Firms should also ensure that systems and processes are ready to robustly manage reliance on fallbacks post-cessation and that the firm’s risk management takes full account of this reliance.
- All legacy sterling LIBOR contracts should, wherever possible, have been amended by end of the third quarter of 2021 to include at least a contractually robust fallback that takes effect upon an appropriate event, or, preferably,
an agreed conversion to a robust alternative reference rate. Actions with respect to non-sterling exposures should be consistent with the relevant timelines for that currency.
- There remains much more to do to ensure that SONIA futures and options markets develop in sufficient depth to minimize the risks of LIBOR cessation to firms’ non-linear exposures. Firms should take active steps to build further liquidity in these products in advance of the upcoming Working Group milestone to cease new GBP LIBOR futures and non-linear derivatives by the end of the second quarter of 2021, other than for risk management of existing positions. Firms should also support the transition to euro short-term rate (€STR) before the discontinuation of EONIA on January 03, 2022.
- PRA plans to write to firms, in April, to set out its expectations for Internal Model Approach under the market risk models and, in June, for Internal Model Method under the counterparty credit risk models. PRA expects all formal model change applications to be submitted by the end of September 2021.
A key milestone recommended by the Working Group on Sterling Risk-Free Reference Rates is to cease initiation of new GBP LIBOR-linked non-linear derivatives expiring after 2021, by the end of the second quarter of 2021, other than for risk management of existing positions. FCA and BoE a separate statement supporting and encouraging all participants in the sterling non-linear derivatives market to take the steps necessary to prepare for and implement these changes to market conventions on May 11, 2021 and shift liquidity away from GBP LIBOR to SONIA. BoE also published a market notice that sets out its risk management approach to collateral referencing all LIBOR rates for use in the Sterling Monetary Framework. Pursuant to this market notice, a haircut add-on will be applied to all LIBOR Linked Collateral. The haircut add-on will be 10 percentage points from (and including) April 01, 2021, 40 percentage points from (and including) September 01, 2021, and 100 percentage points from (and including) December 31, 2021.
Keywords: Europe, UK, Banking, Securities, LIBOR, Credit Risk, Risk-Free Rates, Benchmark Reforms, LIBOR Transition, Regulatory Capital, Market Risk, Internal Models, Basel, FCA, PRA, BoE
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