With the impending demise of the longstanding key interest rate index, millions of adjustable rate contracts need to be revised. Here’s how to turn a logistical headache into an opportunity for modernization.
With less than two years to go, financial institutions and corporate treasuries are preparing for a world without LIBOR. The biggest task: modifying client and counterparty contracts, a process known as repapering.
Set to expire at the end of 2021, the London Interbank Offered Rate (LIBOR) has long been the dominant benchmark interest rate for adjustable rate financial products. The majority of LIBOR transactions are derivatives, but with millions of corporate loans and home mortgages also indexed to LIBOR (for a total of$350 trillion), its demise will be widely felt across industries.
Nowhere will the impact be greater than financial institutions and corporate treasuries, which have to repaper and renegotiate millions of contracts that expire after 2021 and index LIBOR with no risk-free rate (RFR) fallback language.
Repapering is complex and involves multiple steps, from impacted contracts and language identification, to final agreement with clients and counterparties. Regardless of their size, organizations face substantial work ahead. Here’s a clear path to getting started and succeeding in the repapering process:
Assess the number of contractsaffected. Developing a sample study of contracts, prioritized by clients and positions, is the first step to getting a handle on the scope of repapering. Prioritization should be based on the valuation of exposures, including off-balance sheet products. Target valuations using new indexed curves should also be produced, with specific attention to hedge accounting transactions.
Many financial institutions don’t have an inventory of their contracts, or even a close estimate of the number of contracts. Taking stock of where contracts sit within the organization, how many there are and the form in which they’re stored is a key initial step for repapering. How many are paper-based? How many are digitized?
Build an operating model and a transition plan. Organizations often move ahead with efforts to digitize LIBOR-based contracts without developing a comprehensive operating model. It’s a key step, however. Taking the time to define key building blocks, processes and roles and responsibilities across the enterprise is just as important to the repapering process as contract digitization, especially given the large volume of LIBOR contracts that need to be transitioned within a short window of time. Once you have defined the operating model and completed the assessment, you can build a solid transition plan.
Implement OCR and trained machine learning. Scanned contracts present significant challenges. The quality of optical character recognition (OCR) is variable depending on the generation of the solution and its ability to properly recognize characters, manual annotations and redundant pages. While a 10% exception rate is widely expected for text-based documents, that number can easily jump to 30% in our experience, creating significant rework.
Many institutions expect to create ad hoc AI engines to fully digitize OCR’d contracts with the relevant meta data. But machine-learning algorithms need time to be trained. The richer the metadata, the fewer exceptions and the less rework.
Don’t wait for final consensus on language remediation. Consensus on fallback language remains a work in progress. Yet without it, LIBOR’s demise looms as a “DEFCON 1 litigation event,” according to Michael Held, general counsel for the Federal Reserve Bank of New York.
Some progress is being made. The Alternative Reference Rates Committee (ARRC) – the U.S. working group tasked with identifying a new reference interest rate and fallback language – has extended the feedback period for adjustable rate mortgages and published clarifications last August for floating rate note (FRN) transactions.
Perhaps because of the slow pace of decisions – not to mention the tremendous scope of the migration effort – we see a lot of organizational procrastination when it comes to LIBOR-related language remediation.
Even with the year-end results, these overall recommendations will not fit all situations and should push organizations to develop solutions that combine AI and rules-based systems, and plan for remediation.
Launching the repapering processes
Once processes, roles and responsibilities are defined, LIBOR program execution can begin, enabled around these key functions:
Comprehensive contract management. Uploading contracts into a CLM system is often a new step for financial institutions and corporate treasuries. These systems provide an organized way to store, annotate and track workflow, right up to the client or counterparty signature. Earlier and more basic versions of CLM tools are widely used by legal departments, and some organizations may find they can repurpose these existing systems for LIBOR migration.
Operations management, as well as management for stakeholders across the organization, including legal, risk, finance and IT. Key tasks include monitoring each department’s progress toward compliance and exploring opportunities to automate workflows across each department.
Alignment across the enterprise with other systems, such as trading, collateral management, core banking and legacy contract management systems.
While LIBOR phase-out is a logistical headache, it also represents a window of opportunity: Modernizing contract processes that are fragmented and outdated is an important advance for every organization. What’s more, advanced contract management solutions can help serve other purposes, such as the requirements for qualified financial contracts (QFCs), know your customer (KYC) and client onboarding.
Now is the time to convert the countdown to LIBOR into an opportunity.