European Banks’ Libor Tail Risks Subside
European banks’ tail risks associated with the transition from legacy Libor benchmarks are subsiding, Fitch Ratings says. The transition is benefitting from the efforts of authorities in the region to corral the industry to migrate to using new risk-free rates and amend legacy debt and derivative contracts to reflect replacement fall-back rates.
However, while progress is good for sterling, euro and Swiss franc fixings, it is slower for the US dollar and yen equivalents. This means that internationally focused European banks with US dollar and Japanese yen Libor debt exposures remain exposed to residual operational, legal and potentially reputational risks from Libor’s transition.
Significant progress has been made on transitioning primary market issuance from sterling Libor to Sterling Overnight Index Average (SONIA), with cumulative issuance of SONIA-linked floating-rate notes totalling GBP82.3 billion at end-May 2021, and SONIA swaps totalling GBP14,240 billion, compared with GBP17,271 billion of sterling Libor swaps.
Meanwhile, Euribor has been reformed to comply with EU benchmark requirements and will continue to be used for variable-rate debt and derivatives.
Progress has been made for Swiss franc Libor but more slowly than for sterling Libor. Swiss Average Rate Overnight (SARON) debt issuances have increased but volumes are still relatively low. Similarly, development of SARON-based swap markets has been slower than for SONIA-based swaps, raising the prospect of a ‘big bang’ transition towards the end of 2021 rather than a gradual transition. Nonetheless, the Swiss Financial Market Supervisory Authority outlined in its transition roadmap that new contracts should generally be based on risk-free rates by end-June 2021, with full operational readiness required by end-2021.
Legislative fixes from the EU and UK authorities are also gathering pace to mitigate risks to lenders from so-called ‘tough legacy contracts’. These are contracts that parties are unable to convert to a non-Libor benchmark or amend to reflect fall-back rates that would operate when Libor is discontinued. The UK Financial Conduct Authority (FCA) recently consulted on powers that will require the publication of certain sterling and Japanese yen Libor fixings for one year after end-2021 on a synthetic basis (but extendable for up to 10 years with annual reviews). Although the legislation does not define the term ‘tough legacy’ or detail how the FCA tools should be used, this legislation could give more time for European banks to run down their legacy contracts. Otherwise, without effective mitigation in place, lenders could be exposed to legal disputes and reputational damage due to contractual uncertainty.
In contrast to the progress with Libor transition in Europe, there is less clarity on the successor rates for US dollar Libor and, to a lesser extent, for Japanese yen Libor, with the relevant authorities being less assertive than those in Europe. In Japan, three successor benchmarks are available. However, with the end-2021 deadline for Japanese yen Libor transition rapidly approaching, the authorities’ tolerance for a multi-rate environment may lengthen the time needed to generate sufficient derivative market liquidity.
In the US, progress on establishing Secured Overnight Financing Rate (SOFR) to replace Libor is also slow as several replacement rates with implicit credit risk components are vying with overnight and term SOFR in cash markets. The transition deadline for one-day, one-month, six-month and one-year US dollar Libor has been delayed to June 2023 to give stakeholders to existing transactions more time to transition, while legislation may help reduce litigation and operational risk for tough legacy contracts.
However, notwithstanding the uncertainty regarding multi-rate environments, European banks with international operations, particularly larger systemically important banks, are working to operationalise several successor benchmark rates for Japanese yen and US dollar Libor in time to meet the respective transition deadlines.
Source: Fitch Ratings