The transition to the Secured Overnight Financing Rate (SOFR) as a LIBOR replacement after 2021 creates layers of risk for banks. Many of these risks are readily apparent, others less so. But the factors banks must consider while choosing replacement rates and correctly implementing contractual fallback language makes a seamless transition a daunting proposition. Though sometimes overlooked, model risk managers have an important role in ensuring this happens correctly and in a way that does not jeopardize the reliability of model outputs.   

LIBOR, SOFR and the need for transition

A quick refresher: The London Interbank Offered Rate (LIBOR) currently serves as the benchmark at which major global banks lend to one another on a short-term basis in the international interbank market. LIBOR is calculated by the Intercontinental Exchange (ICE) and is published daily. LIBOR is based on a combination of five currencies and seven maturities. The most common of these is the three-month U.S. Dollar rate.

Accusations of manipulation by major banks going back as early as 2008, however, raised concerns about the sustainability of LIBOR. A committee convened by the Federal Reserve Board and the Federal Reserve Bank of New York in 2017—the Alternative Reference Rates Committee (ARRC)—identified a broad Treasury repurchase agreement (repo) financing rate as its preferred alternative reference rate to replace LIBOR after 2021. This repo rate (now known as SOFR) was chosen for its ability to provide liquidity to underlying markets and because the volumes underlying SOFR are far larger than any other U.S. money market. This combination of size and liquidity contributes to SOFR’s transparency and protects market participants from attempts at manipulation.

What Does This Mean for MRM?

Because the transition has potential bearing on so many layers of risk—market risk, operational risk, strategic risk, reputation risk, compliance risk, not to mention the myriad risks associated with mispricing assets—any model in a bank’s existing inventory that is tasked with gauging or remediating these risks is liable to be impacted. Understanding how and the extent to which models are considering how LIBOR transition may affect pricing and other core processes are (or should be) of principal concern to model validators.

Ongoing Monitoring and Benchmarking

Regulatory guidance and model validation best practices require testing model inputs and benchmarking how the model performs with the selected inputs relative to alternatives. For this reason, the validation any model whose outputs are sensitive to variable interest rates should include an assessment of how a replacement index (such as SOFR) and adjustment methodology were selected.

Model validators should be able to ascertain whether the model developer has documented enough evidence relating to:

• Available reference rates and the appropriateness of each to the bank’s specific products
• System capabilities for using these replacement rates with the bank’s products.
• Control risks associated with unavailable alternative rates

Fallback Language considerations:

Fallback language—contractual provisions that govern the process for selecting a replacement rate in the event of LIBOR termination—should also factor into a validator’s assessment of model inputs. While many existing fallback provisions can be frustratingly vague when it comes to dealing with a permanent cessation of LIBOR, validators of models that rely on reference rates as inputs have an obligation to determining compliance with fallback language containing clear and executable terms. These include:

• Specific triggers to enact the replacement rate
• Clarity regarding the replacement rate and spread adjustments
• Permissible options under fallback language – and whether other options might be more appropriate than the one ultimately selected based on the potential for valuation changes, liquidity impact, hedging implications, system changes needed, and customer impact

In November 2019, the ARRC published the finalized fallback language for residential adjustable rate mortgages, bilateral business loans, floating rate notes, securitizations, and syndicated loans. It has also actively engaged with the International Swap Derivatives Association (ISDA) to finalize the fallback parameters for derivatives.

The ARRC also recommended benchmark replacement rates adjusted for spread that would replace the current benchmark due to circumstances that trigger the replacement. The recommendation included the following benchmark replacement waterfalls. Validators of models relying on these replacements may choose, as part of their best practices review, to determine the extent to which existing fallback provisions align with the recommendations.

Replacement	Description
Term SOFR + spread adjustment	Forward-looking term SOFR for the applicable corresponding tenor. Note: Loan recommendations allow use of the next longest tenor term SOFR rate if the corresponding tenor is unavailable
Compounded SOFR + spread Adjustment	Compounded average of daily SOFRs over the relevant period depending on the tenor of USD LIBOR being replaced
Relevant selected rate + spread adjustment	Rate selected by the Relevant Governmental Body, lender, or borrower & administrative agent
Relevant ISDA replacement rate + spread adjustment	The applicable replacement rate (without spread adjustment) that is embedded in ISDA’s standard definitions
Issuer, designated transaction representative or noteholder replacement + spread adjustment	An identified party will select a replacement rate, in some cases considering any industry-accepted rate in the related market. Note: in certain circumstances this step could be omitted

Model risk managers can sometimes be lulled into believing that the validation of interest rate inputs consists solely of verifying their source and confirming that they have been faithfully brought into the model. Ultimately, however, model validators are responsible for verifying not only the provenance of model inputs but also their appropriateness. Consequently, ensuring a smooth transition to the most appropriate available reference rate replacement is of paramount importance to risk management efforts related to the models these rates feed.

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RESOURCES:

https://www.insideafricalaw.com/blog/benchmark-reform-the-impact-of-libor-transition-on-the-african-project-finance-market

https://www.occ.treas.gov/news-issuances/bulletins/2020/bulletin-2020-68.html

https://www.isda.org/a/n6tME/Supplemental-Consultation-on-USD-LIBOR-CDOR-HIBOR-and-SOR.pdf

https://www.investopedia.com/terms/l/libor.asp

https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC-factsheet.pdf

https://www.newyorkfed.org/arrc/sofr-transition

https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2019/LIBOR_Fallback_Language_Summary

https://www.isda.org/a/n6tME/Supplemental-Consultation-on-USD-LIBOR-CDOR-HIBOR-and-SOR.pdf

http://assets.isda.org/media/50b3fed0/47be9435-pdf/

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The information within this section has been taken directly from the https://www.occ.treas.gov/news-issuances/bulletins/2020/bulletin-2020-68.html [AR1]