IBOR ORIGINS: A MOON-LANDING IN THE 1969 BANKING UNIVERSE
In 1969, Neil Armstrong walked on the moon, Richard Nixon became president of the United States and 400,000 hippies descended on a sleepy farm near Woodstock. On the other side of the Atlantic, on a winder’s day in London, a Greek banker named Minos Zombanakis was taking his own small step into the history books. Knowing that no single bank would loan $80 million at a fixed rate (and thereby being exposed to fluctuations in the cost of funding) to a developing country like Iran that at the time that didn’t have enough foreign currency reserves to cover the debt, he came up with the solution. To charge borrowers an interest rate recalculated every few months (that reflected the cost of funding for the banks) and funding the loan with a series of rolling deposits. Zombanakis called the rate of the Iranian syndicated loan ‘London Interbank Offered Rate’ (LIBOR), which was as revolutionary in the staid world of 1960s banking as the moon landing, though celebrated with less fanfare.
By 1982 the syndicated loan market ballooned to about $46 billion and virtually all those loans used LIBOR to calculate interest charged. And as London’s financial markets in derivatives, bonds, and loans exploded – especially through Margaret Thatcher’s “Big Bang” financial deregulation program of 1986 – LIBOR became the benchmark to price floating rates, from loans and bonds to trillions of dollars in derivatives contracts.
IBOR FAILINGS: THE IBOR MOON IS MADE OF BLUE CHEESE
Due to the decline of unsecured interbank lending resulting from the collapse of Lehman Bros. in 2008 and then the 2012 LIBOR scandal, it was clear that IBOR was no longer fit-for-purpose. Therefore, National FSI regulators mandated a replacement for all interbank offered rates (IBOR) including LIBOR, EONIA, EURIBOR, CIBOR, NIBOR and STIBOR – all used massively in the financial industry and markets globally. The financial industry has now started the transition from the typically non-transaction based IBORs to the chosen transaction-based risk-free alternative reference rates (ARR) . These new rates differ from IBOR in the following ways:
- ARRs are constructed differently to IBOR. ARR’s are overnight rates, borrowed partially on a secured basis – depending on the currency
- ARR’s reference actual market transactions
- ARRs are nearly risk-free because they are anchored to National Bank reserves, whereas IBOR reflects the perceived credit risks between panel banks
- Fixings for ARR rates, therefore, tend to be lower. This could mean, that a trade transitioning from IBOR to an ARR has a different market value over time than it otherwise would have had.
The successful adoption of the new reference rates is expected to be a long and time-consuming effort. The respective national reserve banks have invited major banks, authorities, associations, selected investment companies, insurance companies and corporates to participate in working groups to discuss approaches and post recommendations for the transition. The deadline for this transition has been extended to the end of 2021.
The working groups typically focus on the following key challenges of adoption:
- Transition to overnight rates and fallback recommendations for legacy contracts
- Implications for discount curves and collateral rates
- Approaches for a transition of discount curves (hard switch or phased switch from old to new discounting schemes or parallel phasing of old and new ones)
- Potential derivation of longer tenor money market rates from new overnight rates
- Fallbacks for longer tenor IBOR rates and their implication on discount rates
- Sufficiently active markets for liquid quotes and real transactions
Due to its scale and complexities, it is necessary to run the IBOR transition through a bank-wide programme and link it to the progress of the working groups.
TRANSITIONING ONTO ARR: A MUCH MORE CHALLENGING MOON-LANDING THAN 1969
Many financial firms already have or are conducting impact assessments to understand how the IBOR to ARR transition would affect their products, technology and overall business. The key output of the impact assessment is to set out an enterprise-wide transition roadmap to be adapted as working groups issue further recommendations and clarifications. The relevant product universe that is impacted is large and is the fundamental driver of what makes replacing IBOR such a key challenge. At the highest level, the following products will be impacted:
- All IBOR based term/RCF/Money Market loans
- All IBOR-based commercial papers and other long- and short-term bonds and repos
- Trade discounts
- Liquidity deposits
The transition applies to almost every financial services domain: banking, capital markets, insurance and asset management. Consequently, this will affect functional areas such as valuation, risk management, technology, operations, accounting, controlling, tax, legal, regulatory, compliance and governance:
As a result, IBOR transition is expected to require a significant effort to analyse the as-is state, imminent implications, alignment of strategy, products, processes, systems, organisation and data before implementing the transition across the enterprise while simultaneously mitigating operational, conduct and financial risks.
Many financial institutions have completed – or are in the process of completing – impact assessments to definitively identify their “IBOR footprint” across their debt instruments. They now have just under two years to replace this footprint across the value chain of the banking enterprise with ARR. Given the scale and complexity of operations for many banks – and the huge variety of areas across the enterprise where floating rate indices occur – this timescale is set to be very challenging. Therefore, banks need to make IBOR replacement front and centre of their transformation portfolio and resource and fund the implementation accordingly.
Alex is an experienced professional who has successfully delivered group-wide Business and IT transformation programmes in Financial Services driven by regulatory pressures or by major business change initiatives to improve operational efficiency.
Neeth is an experienced risk, regulation and technology professional within the Financial Services Industry who has been consulted by many banking clients over the years to successfully deliver key transformations.