10 RISIKO MANAGER 10|2018 Implications of EONIA and EURIBOR reform on banks Getting Ahead of the New Curve in Reference Rates EONIA and EURIBOR are the reference rates for financial contracts with a nominal value of more than € 150 trillion. But they are about to be replaced. The quantity of unsecured interbank lending has collapsed and, following the LIBOR price-manipulation scandal, regulators seek to reduce the role of expert judgement in setting reference rates. By January 2020, EONIA will be replaced by an entirely new short-term (overnight) reference rate, and the derivation of the EURIBOR term-rate will be significantly revised. Because EONIA and EURIBOR are ubiquitous in contracts between banks and their counterparties, and commonly used in valuation modelling and internal transfer pricing within banks, nearly every part of the balance sheet and nearly all front-toback processes are affected. The shifting to new reference rates presents banks not only with one-off transition costs but with significant risk. If the old rates are no longer published, existing contracts referencing them will need to be renegotiated, presenting not only direct financial risk, but also legal, conduct and reputational risks that attend such a sensitive process. Redesigning products, hedges and valuation models for use from 2020 presents the same risks. Get things wrong, and a bank’s balance sheet, legal position and reputation with customers could all be damaged. On a stand-alone basis, the implementation effort for many banks will be comparable to IFRS 9, potentially ¤ 50- ¤ 100M for smaller banks to as much as ¤ 350M for G-SIBs. To make the most of this spend, banks should use the enforced reference rate transition as an opportunity to create synergies with other regulatory or operating model initiatives, upgrading their pricing and risk management frameworks in the process, and move to a more agile and cost-efficient model landscape, data platform and IT infrastructure. Taking advantage of such synergies could reduce the cost of the combined project by up to 20 percent. Out With the Old Rates, in With the New Euro-denominated financial contracts – from simple mortgages to complex derivatives – rely on two main “reference rates”: the euro
OpRisk 11 Ex. 01 Timeline for introduction of new reference rates Instrument 2017 2018 2019 2020 2021 Regulator Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Launch of new RFR working group Designation of ESTER as RFR O/N Term curve development? (not yet planned) Deadline for compliance with benchmark regulation Deadline for RFR and term curve go-live SOFR 1 published SOFR 1 as RFR O/N go-live SOFR Futures & IRS debut Term curve development Creation of a RFR term curve Term curve development SONIA go-live Trading futures (reform implemented) SONIA-based Initial term rates available FCA 2 to stop guaranteeing LIBOR 1. Secured Overnight Financing Rate; 2. UK Financial Conduct Authority Quelle: BCG. Today RFR go-live Key event overnight index average (EONIA), derived from overnight unsecured interbank transactions, and the euro interbank offer rate (EURIBOR) for monthly tenors up to 12 months, based on submissions from a panel of banks. Both rates concern unsecured lending between banks. Since the financial crisis, however, transaction volumes in these markets have declined by more than 90 percent. And, following the LIBOR price-fixing scandal, reliance on expert judgement has become a point of concern for regulators. Hence the publication of a set of principles for financial benchmarks by International Organization of Securities Commissions (IOSCO), and another by the European Banking Authority (EBA) together with the European Securities Market Authority (ESMA), which specify standards of quality and independence for financial benchmarks. A review of the existing euro reference rates deemed them to be inconsistent with the specified principles. EONIA volumes are so low that it will need to be replaced, while EURIBOR needs to be revised so that it relies less on the expert judgement of a small number of panel banks. The deadline for the application of new benchmarks is January 1, 2020. The replacement for EONIA has been settled. In June 2018, the ECB’s Governing Council decided on the final methodology for calculating the euro short-term rate (ES- TER), which will reflect the observed wholesale euro unsecured overnight borrowing costs of banks in the Eurozone (with expected volumes of about ¤ 30 billion per day). The methodology for calculating ESTER was determined taking into account feedback received in two public consultations and in line with the international standards set by IOSCO on financial benchmarks. ESTER is highly correlated with EONIA (the average spread being +9bps from 2016-18), though less volatile. ESTER will officially be published from October 2019 based on data already available to the Eurosystem. The revision of EURIBOR, however, is not yet finalized, and consultation will continue through the second half of 2018. EMMI, the publisher of EURIBOR, has suggested a hybrid method, drawing on both observed market rates and submissions from panel banks in a three-step process that complies with the new principles on reference rate fixing. However, maintaining a term structure for EURIBOR (so that the reference rate varies with time to maturity) remains a methodological sticking point. Nor is the transition process yet clear. The old rates may continue to be published for some period after the new rates are introduced, or they could come to an abrupt end (although this seems unlikely). And jurisdictions are making the transition at different speeds. (See Exhibit 1). While the substitution of EONIA and EURIBOR are still many months away, futures contracts referencing replacements for short-term indices have already gone live in the US and UK – respectively, the Secured Overnight Financing Rate (SOFR) based on the Treasury repurchase market, and the Sterling Overnight Index Average (SONIA). The Transition Is a Challenge for Any Bank Shifting away from the old reference will require banks to redesign not only the products that now refer to them, but also the valuation, hedging and other risk management models that use them as a key parameter. Internal steering mechanisms will also need modification. For example, funds transfer pricing (FTP) for a vanilla fixed-rate loan is usually constructed from the variable deposit rate and a swap (which would use the reference rate). The transition to a new reference rate may therefore entail changes to the FTP and, hence, to measured performance of the business units. Targets and other performance-based steering mechanisms must be adjusted accordingly.