London 6th October - Originally published by Reuters Regulatory Intelligence on 29th September Delta Capita’s Philip Freeborn and George Petropoulos discuss the countdown to RFR and what financial organisations should be doing.
As deadlines for interbank offered rates (Ibor) transition get ever closer, banks and other financial institutions need to ensure they are properly prepared. This article summarises the main areas boards should be considering in the run-up to the transition.
The authors' recommended approach not only requires huge effort from the first line of defence in financial institutions, but also substantial efforts from second (operational risk and new risk limits) and third (audit) lines. It is quite common for third parties to be brought in to support each of these areas, to supplement internal expertise. Boards often want independent assurance that the risks to the financial institution are offset.
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Internal communication and training
Financial institutions need to provide regular updates to all stakeholders, given the deadlines and constantly evolving nature of the transition. Although there are widely publicised dates for the cessation of Ibors, unanswered questions remain. Staff in affected departments will need detailed e-learning, together with technical updates as the outstanding issues are resolved. This will need to be supplemented by product training on the redesigned standard products. Financial institutions should also provide specific training on the particular challenges of the transition, and on how to offset potential conduct and reputational risk.
External communication to clients/customers
Clients should be kept informed of potential operational and/or financial implications for them and for their choices, and be told to whom they can speak if they have questions. This should not be a one-off exercise but rather a continuous process, as the outstanding questions that may affect clients are gradually clarified in line with the latest developments. Financial institutions need to establish and maintain processes to handle client communication by product and customer classification, and put in place complaint-handling procedures. Many will need to augment their in-house teams and skill sets with external help to deal with the volume of client communication.
External communication to regulators
Regulators' expectations are high, and they expect to be kept abreast of financial institutions' progress toward, and readiness for, the transition. In the UK, where prudential and conduct risks are managed by two different regulators, each needs to be regularly updated to ensure the messaging on progress is consistent.
Implementation of the new rates in internal systems
This requires clarity about product pricing and monitoring of amended products across the front, middle and back offices, as well as enhanced reporting across risk and finance. The strain put on quants inside financial institutions from a plethora of new regulations, from Brexit and, more recently, volatility from the COVID-19 pandemic, requires new model development/model updates. Backoffice systems will also need to be further developed to accommodate the new rates and updated payment information and payment instructions. All models need to be validated by the independent second line of defence validation quants. A substantial testing overhead will be required across all the amended systems and models.
CCP early transition events
There will be substantial work to accommodate early transition of cleared derivatives. Infrastructures will need further development so they can deal with cash compensation, rebooking and cancelling of trades. Preparations should also be made to manage the effects on bilateral trades.
Updated legal and contractual terms
There is also a need to update legal contracts between financial institutions and their professional counterparties, large corporates, small and medium-sized enterprises, wealth clients, mass affluent and retail clients. Many contracts will include references to Ibor, and will need to be amended to reflect the new fallback language. This would be a significant challenge even if financial institutions had a common starting point for each type of client contract. The process of contacting clients and customers and handling the questions will require great skill and strong logistical coordination. Many financial institutions are supplementing their own legal functions with thirdparty help. Contract language has evolved over time, however, and it will be a challenge to suggest different amendments for different reasons for different versions/ages of contracts. Many older contracts have not been digitised, and financial institutions are using this to spur the move toward digitisation, given that this may be just the first change of many in the next few years. Here too, this process may be best accelerated by using industrial solutions provided by third parties.
Strategy development
Given a potential scenario of gapping prices before and soon after the transition, financial institutions need to design and implement clear hedging strategies that will offset all financial risks (market, credit and liquidity) and adjust their risk appetites. They will need to have a clear transition strategy, given the early transition events up to the Ibor cessation date, to offset all financial risks.
Risk control
The second line of defence needs to update risk methodology and risk appetite to be consistent with the new rates, and the operational risk function needs to assess new business processes.
Internal and external assurance
Banks and financial institutions need to provide assurance that the organisation is ready by using appropriate board reporting. They should also provide internal audit reviews and/or consider using independent expert third-party review.
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