EBA Note Examines Transition Risks of Benchmark Rates
The European Banking Authority (EBA) published a thematic note that aims to identify and raise awareness of the transition risks of benchmark rates, as the London Interbank Offered Rate (LIBOR) and the Euro Overnight Index Average (EONIA) are close to being phased out. The note identifies pockets of transition risks for banks in the European Economic Area (EEA), resulting from their significant exposures linked to LIBOR and EONIA rates. The note highlights that banks and competent authorities consider that legal challenges associated with the transition of existing business of the assets side as well as the required changes in internal operations and systems of banks remain key areas of concern.
Banks in European Union (EU) have reported significant derivatives and loan exposures linked to various LIBOR currencies and tenors as well as EONIA rates that will cease at the end of the year. A very high percentage (more than 25%) of EU/EEA banks’ derivatives exposure is linked to LIBOR, reaching nearly EUR 50 trillion (notional amount). In addition, about EUR 1 trillion of loans and advances are linked to various tenors of LIBOR and EUR 0.2 trillion of loans and advances are linked to EONIA rates. CHF LIBOR referenced loans are a particular focal point in this analysis as political risks add to the existing legal transition risks for these loans. Transition of important benchmark rates bear elevated risks, as these rates play a major role in banks’ daily business, including in valuation and risk management. Thus, acknowledging and addressing the underlying risks should be a key priority for market participants.
The note shows that banks still hold major volumes of assets, liabilities, and derivatives related to ceasing benchmark rates. Banks need to address the changes to affected contracts, which so far do not include, for instance, any fallback language, and need to check their robust written plans setting out the actions they would take in the event that a benchmark ceases or materially changes. Keeping clients and other counterparties informed about the upcoming changes is also part of this work. It is important that all parties involved in the transition process cooperate, including banks, their clients, and other counterparties as well as regulators and supervisors. Banks, like any other market participants, should adhere to guidance given by regulators and other authorities involved in the transition of benchmark rates. If benchmark rate transitions affect, for instance, banks’ internal models or prudent valuations an early exchange with their supervisors is important. Addressing potential legal or conduct-related risks related to the transitions also remains important for banks, along with the risks associated with transitioning the information and communications technology (ICT) systems. Thus, it is key that transitions of benchmark rates are managed diligently and timely within the remaining months.
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Keywords: Europe, EU, Banking, LIBOR, EONIA, Risk Free Rates, Benchmark Reforms, Benchmark Fallbacks, Derivatives, Basel, EBA
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