Breakfast session on IBOR reform
The EURIBOR, EONIA and LIBOR changes are coming closer and still there are a lot of uncertainties. Risk and treasury managers from small and midsize banks discussed the key challenges at the first Zanders breakfast session on IBOR reform. Most attention was paid to the impact on risk models and the valuation of legacy contracts.
After a short introduction into the scope of the IBOR reform, we discussed several topics that banks are facing in the transition. Part of the complexity of the reform is the fact that for every benchmark rate the transition is different. In some markets, the non-compliant overnight rates will be replaced by existing rates, while in other markets new benchmark rates will be created. The latter is the case for the euro zone, where EONIA will be replaced by the euro short-term rate (€str), a transaction-based overnight rate that will only be published from October 2019. It gets even more complicated when we look at the term structure rates. In some jurisdictions, the term rates will be discontinued without any replacement. In the euro zone, the European Money Markets Institute (EMMI) has applied for authorization of the hybrid EURIBOR, a term rate based on a waterfall methodology prioritizing transaction data over panel bank’s submission to determine the rate.
Do we really need a floating term rate?
In the discussion group, almost everyone agreed that it would be very convenient to have floating term rates like those currently used, such as 3- or 6-month rates. However, the picture changed when we discussed whether it is really necessary. It was stated that most of the problems arising from a discontinuation of the term rates would be operational and could be overcome with some preparations. Instead of using a term rate, the overnight rate could be compounded over a certain time, with the only difference being that the rate would not be known in advance but rather at the end of the period. While this seems like a small change from a banking perspective, it was mentioned that it could be tricky to make this change when dealing with retail clients and that it requires a change in mind set. Despite this, there are several advantages from a risk and treasury perspective in having only one floating rate. For example, you will have only one interest rate curve.
One participant, a treasury manager at a bank, stated that a market with only an overnight rate would be the “purest” solution and not having a term rate would reduce complexity in risk and treasury management. Many others agreed with that view and the question was raised if the hybrid EURIBOR might in the end only be a temporary solution that gives the market more time for the transition. In a hypothetical scenario, where it is known that the hybrid EURIBOR will be discontinued at a certain date, the market would have time to transition out naturally by not entering into new contracts that are referencing the term rates.
How will regulatory models be impacted by the reform?
The participants raised the change implied by the IBOR reform and the use of the new reference rates in the regulatory models as issues that need to be addressed. Two challenges were discussed. Firstly, historical data is frequently used as input to the models, so what should be done when historical data is not available? The second challenge relates to the volatility of the rates used in the model. For example, €str has a lower volatility than EONIA for the last two years - something that can significantly impact the model outcome - but does it make sense to have a sudden change of model outcomes at transition date?
Participants agreed that it does not make sense to have a capital release, for example due to the change of reference rate, as intrinsically the balance sheet risk of the bank will not change at the transition date. Will the supervisory bodies instead allow the use of adjusted historical data (i.e. old reference rate plus spread)? Participants hope and expect that supervisors will provide guidelines in order to have a smooth transition.
After two hours of discussion, all attendants left with new insights and some new questions in their heads too. When there are new developments, we will certainly have to meet again.
Would you like to join our next session or do you want to hear more about EURIBOR, EONIA or LIBOR related issues?
Contact Marie Gotthardt on +31 35 692 89 89.