It was 2017 when Andrew Bailey announced that LIBOR, the most important number in finance, would be retired. It has been more than three years since the speech yet the banking industry cannot agree on a common transition approach. The deadline of 2021 is fast approaching and banks face new and more complex challenges. The need for adequate software solutions has never been greater.
Nothing about this transition is constant, except for the credit adjustment spreads on fall-backs. In 2017, there were questions but no answers. Today, the number of answers exceeds the number of questions and banks have more options than they would have preferred originally. The lack of uniformity is apparent and the pace of transition in each jurisdiction and for each asset class is different.
It was the daily rate compounding in arrears at the beginning, which was already fundamentally different compared to how banks used LIBOR. Attention was then turned to alternative conventions such as lockouts and lookbacks – the approach taken for derivatives was deemed inconvenient for loans. Banks need capabilities to process products using different market conventions and rate averaging methods.
While it seemed consensus was reached and banks had clear answers, change was not late to come. Different jurisdictions decided to adopt different versions of lookback, the recommended convention for cash products. The Swiss market embraced Observation Shift and the UK and the US authorities suggested Lookback without Observation Shift. Banks not only have to support multiple market conventions for different asset classes but also variations within a given convention.
To complicate the matter even more, recent regulatory publications give banks three options to calculate compound interest: 1) cumulative rate compounding; 2) non-cumulative rate compounding; 3) amount (or balance) compounding. In other words: 1) ISDA; 2) Bank of England; 3) ARRC. Mathematically speaking, all three methods give the same result when the principal of a contract remains unchanged during a given interest period. When an intra-period event such as principal change happens, all three methods result in different accrued interest.
Irrespective of the preferred method by a given bank, there is an imperative to support all options. Banks have to adapt to their counterparties’ preferences and business models. The simple example of syndicated lending is sufficient to clearly illustrate this need – when the syndication agent requires cumulative rate compounding for Lookback of five business days without Observation Shift, the lender cannot justify their Treasury Management Systems or Core Banking software’s incapability of supporting the necessary calculations.
Daily Rate Compounding, Lockout, Lookback, Observation Shift, Cumulative Rates, Non-Cumulative Rates, Amount Compounding. When Risk-Free Rate Flooring is added, the puzzle becomes even more complex.
Software solutions catering for all the options are essential for banks to stay competitive, ensure compliance and future-proof their software investments. Banks should see their software providers not only as vendors but also as strategic partners and consultants. The right software can help banks unlock the immense hidden value the transition brings, especially during the current uncertain economic environment.
The retirement of LIBOR was announced in 2017. It is 2020 now and one truth has emerged – banks cannot achieve a successful transition without the right software solutions.