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Regulators highlight LIBOR transition risks

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Banking
Monday, July 6, 2020

Federal financial regulators issued a statement to institutions on managing the transition away from LIBOR, encouraging them to continue work to transition to alternative reference rates.

The statement from the Federal Financial Institutions Examination Council (FFIEC) also highlighted the legal and consumer compliance risks associated with inadequate fallback language, when the contractual language does not contemplate LIBOR’s permanent discontinuance.

“The financial services industry uses LIBOR as a reference rate for many financial products and instruments that include loans, investments, and deposits to a range of customers, as well as borrowings and derivatives,” the FFIEC stated. “While some smaller and less complex institutions may have limited exposure to LIBOR-denominated instruments, the transition to alternative reference rates will affect almost every institution.”

Financial institutions should have risk management processes in place to identify and mitigate their LIBOR transition risks that are commensurate with the size and complexity of their exposure and third-party servicer arrangements, the FFIEC stated.

The statement began by highlighting potential risks, saying institutions could have a number of on- and off-balance sheet assets referencing LIBOR. Among those risks are:

  • Operational difficulty in quantifying exposure;
  • Financial, valuation, and model risk related to reference rate transition;
  • Inadequate risk management processes and controls to support transition;
  • Consumer protection-related risks;
  • Limited ability of third-party service providers to support operational changes; and
  • Potential litigation and reputational risk arising from reference rate transition.

The agencies discussed how the transition would have consumer protection and compliance implications, with retail loans – such as adjustable-rate home mortgages, home equity lines of credit, student loans, credit cards, and other personal loans -- potentially referencing LIBOR.

“If LIBOR is no longer available, a replacement reference rate may be necessary. Any alternative rate not specified in fallback language may impact consumers, increase reputation risk, and result in legal exposure to institutions and the financial industry,” the FFIEC stated.

The agencies said institutions should plan to address or mitigate risks with consumer financial products, and transition plans should identify affected consumer loan contracts, highlight necessary risk mitigation efforts, and address development of clear and timely consumer disclosures regarding changes in terms.

“Disclosure of these altered terms should, and in some cases are required by law to, be communicated to borrowers in advance of a reference rate change to help them understand how a new reference rate affects their contractual principal and interest payments, APR, and other terms,” the FFIEC stated.

There also are considerations for institutions’ work with third-party service providers, with the transition potentially affecting “critical activities” by those providers.

“Institutions should evaluate their reliance on third-party service providers that provide valuation/pricing services that reference or use LIBOR and associated discount curves in the services they deliver,” the FFIEC stated. “Institutions should determine whether those third-party service providers will be able to accommodate alternative reference rates after LIBOR’s discontinuation.”

The statement said third parties that provide modeling, document preparation, accounting or other services also should be considered. Third-party service providers who process of loan, investment, funding, or derivative transactions also should be reviewed.

Finally, the FFIEC pointed out fallback language in financial contracts, saying many existing contracts only contain such language for a temporary, not permanent, end to LIBOR.

“Accordingly, institutions should take steps to identify and address contracts with inadequate fallback language. Assessing existing contracts (including contracts serviced by third parties) could be difficult for institutions with contracts that use a range of fallback language (particularly institutions with merger and acquisition history, and larger, more complex institutions that have separately managed lines of business),” the FFIEC stated. “New contracts should either utilize a reference rate other than LIBOR or have robust fallback language that includes a clearly defined alternative reference rate after LIBOR’s discontinuation. If not sufficiently addressed, inadequate fallback language could pose legal as well as safety and soundness risk.”

For derivatives exposures, the statement said the International Swaps and Derivatives Association is consulting on and will issue a protocol for market participants to include fallback language for legacy LIBOR-linked contracts.

“All institutions should have risk management processes in place to identify and mitigate their LIBOR transition risks that are commensurate with the size and complexity of their exposures. Supervisory focus will be tailored to the size and complexity of each institution’s LIBOR exposures,” the FFIEC stated. “Large or complex institutions and those with material LIBOR exposures should have a robust, well-developed transition process in place. In contrast, for smaller institutions and those with limited exposure to LIBOR-indexed instruments, less extensive and less formal transition efforts may be appropriate.”

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