What is the international reform of interest rate benchmarks?
The London Interbank Offered Rate (LIBOR), considered one of the most important interest rates in finance, and being phased out starting from end of 2021. The industry players are taking steps to prepare for the coming change. Major central banks and regulators have decided to transition from the existing Interbank Offered Rates (IBORs) to alternative Risk-Free Rates (RFRs), also referred to as Alternative Reference Rates (ARRs).
As LIBOR has the most exposure in products in the US, the United Kingdom, Europe, Switzerland and Japan, all of these representative countries have working groups that are seeking to develop possible replacements of LIBOR.
In 2014, the Federal Reserve convened the Alternative Reference Rates Committee (ARRC) to plan the transition away from U.S. dollar LIBOR. ARRC determined the Secured Overnight Financing Rate (SOFR) to be the U.S. dollar replacement rate.
The London Interbank Offered Rate (LIBOR)
The London Interbank Offered Rate (LIBOR) is a benchmark rate at which banks estimate they can lend money to other banks on an unsecured basis
LIBOR Panel Banks
- 11-18 bank individually estimate the rate at which they would borrow from other banks
- Panel banks are asked the rate they would charge other banks for a given currency and a given period of time
- Banks submit rates to Inter-Continental Exchange (ICE) for overall LIBOR index calculation
- ICE discards the highest and lowest submitted rates and calculates the mean of the remaining submitted rates
- LIBOR is calculated for 5 different currencies (USD, EUR, GBP, JPY, CHF) and 7 different maturities (overnight, 1 week , 1 month, 2 month, 3 month, 6 month, 1 year) – 35 LIBORs are required each day
- LIBOR rate is not only an indication of interbank lending, but also used as a benchmark for over-the-counter derivatives, exchange traded derivatives, corporate bonds, business loans (syndicated and non-syndicated), floating rate notes, consumer loans such as mortgages, credit cards, autos, and securitizations
Global financial regulators decided that markets must move away from using LIBOR as a benchmark and have it replaced. The Alternative Reference Rates Committee (ARRC) was formed in 2014 to address concerns about reliability and robustness of existing reference rates in the U.S. One of its main objectives is to explore and provide guidance on alternative rates and to develop overall transition timelines.
The Secured Overnight Financing Rate (SOFR)
- ARRC determined SOFR to be the U.S. dollar replacement rate.
- Replacement criteria included methodological quality, accountability, governance, and ease of implementation
- The New York Fed has published SOFR every day since early April 2018
- It measures the cost of overnight borrowings through repo transactions collateralized with U.S. Treasury securities (the deepest and most liquid money market in the U.S.)
- It is based on actual transactions and takes in more transactions than any other Treasury repo rate available, recently around a trillion dollars each day
- It is relevant to the cost of borrowing for a wide array of market participants
- It is constructed to meet the best practices for benchmarks set out by International Organization of Securities Commissions (IOSCO) and has been built to accommodate future market evolution
Risk Free Rates
Risk Free Rates (RFRs) are benchmarks generally based on overnight deposit rates. It measures the cost of overnight borrowings through repo transactions collateralized with U.S. Treasury securities (the deepest and most liquid money market in the U.S.). For products that require a forward-looking rate, such as Trade and Islamic Finance, a term rate to be available.
- Some of the overnight rates are unsecured with only a very small credit spread and some are secured and exclude credit risk completely. Especially in times of stress, secured and unsecured rates behave very differently. The economic difference to LIBOR, as well as the structural differences among the secured overnight rates corresponding to various currencies raise additional complexity.
How is BBK responding to this?
The Bank is following the market development and the guidelines issued by different regulatory bodies including the Central Bank of Bahrain. Further the Bank continues to align the systems, processes and infrastructures to address the new requirements. The Bank has already identified the impacted areas, contracts and has taken remediation steps to minimize the migration risks. The progress of the initiatives are being monitored by the senior management of the Bank to ensure uninterrupted services to our clientele.
What does this mean for our clients?
We are committed to work with all our clients and maintain transparent communication, for smooth and efficient transition.
The path to transition away from LIBOR is complex due to introduction of new conventions. The risk-free rates are calculated on a different basis to LIBOR. The various jurisdictions have decided to have own currency specific benchmarks. Transition will affect both new and existing products referencing these key interest rate benchmarks, and in different ways. Given that, some benchmark rates are being reformed or will be discontinued and replaced with alternative benchmark.
For further guidance on how to prepare for the transition away from LIBOR or other benchmark rates that will be discontinued or materially changed, please consult your BBK relationship manager. We recommend that you also consult your own legal, tax, financial, and other professional advisors for more specific guidance.
If your facility (or final rate fixing) is before the below dates for the cessation of LIBORs, it may mature naturally, with no required action subject to market movement of the rates and or mutually agreed between the parties to the agreement:
- 31 December 2021 in the case of all sterling, euro, Swiss franc, Japanese yen settings and the 1-week and 2-month US dollar settings; and
- 30 June 2023 in the case of the remaining US dollar settings.
Steps for addressing the transition
- Current status assessment (Facilities, exposures and maturities including impacted pricing benchmarks)
- Overview of outstanding transactions / contracts between Client and BBK that are in scope for transaction repapering
- Options on transition approach:
- Active Conversion: Proactive negotiation of the conversion of transactions with BBK in advance of LIBOR cessation in order to allow for custom outcomes in terms of timing and structure of transactions post conversion; or
- Fall-back Conversion: Allow existing LIBOR transactions to incorporate market standard fallback provisions triggered by a LIBOR cessation event.
2. Agreement transition terms
- The impact on the outstanding transaction(s) in relation to transaction repapering;
- The approach of transitioning for these transaction(s);
- Conventions to use when transition the transaction(s);
- The operational procedure of transitioning the transaction(s);
- The date on which the transaction(s) will be transitioned.
- Appropriately Pricing the transactions that are in scope of transition repapering.
- Execute the transactions that are in scope of transition repapering.
5. Post transitioning support
- Continuing to provide customer support post transitioning, where relevant.
- IBA (Intercontinental Exchange (ICE) Benchmark Administration) confirmed its proposed dates to stop publishing USD LIBOR on a representative basis. Specifically, the FCA (Financial Conduct Authority) announced that the publication of LIBOR on a representative basis will cease for the one-week and two-month USD LIBOR settings immediately after December 31, 2021, and the remaining USD LIBOR settings after June 30, 2023.
- The US Federal Reserve System, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation announced that no new contracts referencing USD LIBOR can be issued beyond 31 December 2021. The UK's FCA has already indicated that GBP LIBOR referencing contracts cannot be issued beyond Q1 2021, if their maturity date extends beyond 31 Dec 2021.
- Regulators in the USA, the UK and the Eurozone area continue to work towards developing term rates based on RFR, which can offer a forward-looking curve for associated contracts. Preliminary versions of Term SONIA (in the UK) have been available since 11 January 2021.
Credit Adjustment Spread
As the market transitions to SOFR, indexes or credit spread adjustments are emerging to help address market participant's concern that SOFR does not have the embedded bank credit component that is included in LIBOR. Therefore, the all-in interest rate for a LIBOR based loan is simply the LIBOR rate for the relevant term plus the bank's commercial margin. In contrast RFRs do not include a credit premium, so to address the divergent behavior between the benchmarks, the industry is exploring the best possible route to mitigate the ''rate difference' risk. The option is to derive a Credit Adjustment Spread (CAS) which is added to the Risk-Free Rate (RFR. Therefore, the all-in rate for a loan transitioned to Risk Free Rates is comprised of three elements: The RFR, plus the CAS plus the agreed commercial margin.
The cessation announcement of LIBOR on 5 March 2021 (FCA announcement on future cessation and loss of representativeness of the LIBOR benchmarks), has resulted in the credit adjustment spreads to be fixed and it is expected that a similar approach will be adopted for the CAS in the loan market.
Any further questions?
For more information on the reform of benchmark rates, please visit the various websites below. You can also reach out directly to your BBK relationship manager. We will continue to update you as interest rate benchmark reforms and transitions develop. The information presented here is not intended to be a complete or exhaustive overview.
Bank of Bahrain and Kuwait B.S.C. (the 'Bank' and/ or 'BBK') is giving to you this information with the understanding that BBK is not rendering definitive legal, business or financial advice to you as client to the Bank. The Bank cannot give you any assurance as to the outcome of any laws or regulations proposals in connection with LIBOR and how it might impact your product. Generally, working to transition your product actively away from an IBOR rate will provide clarity as to the rate of your product after cessation of that IBOR rate. You should consider now, and continue to keep under review, the potential impact of any future changes to IBOR rates.
Although we make strong efforts to make our information accurate and up-to-date taking into account the fast developments in this sensitive area, BBK cannot guarantee that the information is always complete. You are requested to seek advice from your advisors and be kept abreast and well-informed with the developments in this ever evolving environment.Timeline