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12 RISIKO MANAGER 10|2018 Ex. 02 Instrument Guiding principles for an effective reference rate transition 1 Control financial impact » Focus on highly impacted business areas to ensure no big surprise in the P&L or KPIs after transition 6 2 Establish a strong central transition management » Coordinate dependencies between front-office, finance, treasury, risk management, compliance, audit and IT 3 Shape the regulatory discussion and ensure compliance » Quickly assess impact of complying with requirements and shape the discussion with regulators 4 Enforce working across silos » Foster transparency around impact, requirements, transition plans, challenges on all units/functions and their interdependencies 5 Align project portfolios and respective costs to synergistically address the transition » Required transition will affect many projects and IT implementation efforts already planned Think big and drive change » Strive to improve processes, methods and models along the way. Set up the model landscape, data platform and underlying IT architecture for the future With both first- and second-line functions affected, the transition will be costly. BCG estimates range from ¤ 250 to ¤ 350M for G-SIBs and ¤ 50 to ¤ 100M for smaller banks. But this predictable cost is small compared to the risks entailed by the transition. After the transition date of January 1, 2020, many extant contracts will refer to EURIBOR and EONIA rates which may then be unavailable. Financial contracts typically include “fall-back” clauses which specify the rate to be used if the reference rate becomes unavailable. However, these are designed with the assumption that the reference rate will be unavailable for only a short period. Replacing the reference rate with the fall-back rate for the remaining life of the contract could provide one party to the contract with windfall gains and the other with corresponding losses. Or, to put it another way, it could dramatically change the value of the contracts a bank has entered (on both the asset and liability side) and, thus, alter its balance-sheet position. If EURIBOR and EONIA continue to be reported after January 1, 2020, banks would have the option of persisting with the old contracts that reference them. However, this too would entail risk because these rates have been deemed inconsistent with the new IOSCO and EBA principles for reference rates. Banks that continue to use these rates may be exposed to costly regulatory interventions. To reduce these risks, banks will need to renegotiate contracts prior to 2020. However, finding new terms that prevent the bank from incurring losses on each contract could be cumbersome. And the process will be legally perilous, exposing banks to the risk of lawsuits or interference by regulators. These risks will arise even when banks are adjusting rates without contractual impediment. New reference rates will still have the potential to alter the value of products that use them, with the potential to arouse discontent among customers and regulators, especially in the retail banking space where customers are deemed to require greater protection. In short, the introduction of new reference rates presents banks with considerable financial, legal and reputational risks. To minimize them, the transition process, including communication with clients and regulators, must be carefully planned and managed. How to Manage the Transition To successfully manage the transition to the new reference rates, banks will need to undertake a series of tasks, which we outline in this section. » Assess and mitigate the financial impact. Banks must understand the size of their (external and internal) exposures to the transition, and where they are located. This means identifying all the products and contracts to which they are party that reference EONIA or EURIBOR. Once exposures are identified, the bank will need to estimate the gains or losses from moving to the new rates for all instruments, subject to fair-value considerations. This assessment should cover changes in the fair value of assets and liabilities, the P&L impact, and the impact on OCI and on overall capital. In addition, the stability of hedge accounting relationships needs to be reconsidered. This is especially important when the basis for the reference changes, for example, from unsecured to secured, or from the offered side to the bid side. This may require discussions with auditors to avoid any unintended accounting effects. Banks should also attend to the potential impact on regulatory metrics of liquidity or capital, which may need to be recalibrated to the new reference yield curves. They should also consider various scenarios, for example, regarding the ongoing availability of the old reference rates and the timing of changes to products and risk models. This assessment will automatically reveal the lines of business and products that are most affected by the transition and, hence, where efforts should be concentrated. Finally, an action plan to mitigate the financial impact of the transition should be

OpRisk 13 formulated. This will specify actions for the transition period itself (such as avoiding new long-term contracts priced off the old reference rates), and preparations for future business with the new rates such as redesigning products and valuation models to use the new referenc e rates. » Ensure compliance with the new ratefixing method. As noted, EMMI has suggested a three-step rate-fixing method that is internal to panel banks. Management must ensure that the first and second lines of defense are prepared to provide the input demanded by this new rate calculation. Any required changes from the status quo should be identified as soon as possible, so that they can safely be made before 2020. To minimize compliance and legal risk, Chinese walls must be created by a clear separation of the trading businesses from the units involved in calculating and submitting the rates, which might imply some changes in organizational structures and processes. More generally, the process will require efficient governance, controls and policies that ensure the integrity of the rate submissions. » Engage with counterparties. Having identified its exposures, the bank will need to start dealing with the counterparties concerned. First, the bank must identify the contractual details for every contract, perhaps using optical character recognition technology (where legacy contracts are not in digital form), and robotic process automation to handle the potentially vast number of contracts concerned. Second, they need a plan for dealing with these counterparties – perhaps deciding simply to run-off contracts that reference EONIA or EURIBOR (assuming these rates continue to be published), or deciding on terms to recommend when renegotiating contracts so that they reference the new rates. The answers may well vary by customer segment and product. Then the practicalities of the process must be handled. This means deciding how to contact clients – by phone, email, letter or in person – and who should contact them. Again, this communication strategy is likely to vary with the type of counterparty concerned. Is it a retail customer, another bank, a corporation, an SME or a pension fund? Initial contact to explain the new reference rates and the need for contract changes should be made at the lowest cost possible – for example, by using robotic process automation to retrieve a contract from legacy IT systems and generating mail automatically. When counterparties reject the initial proposal, or demand more information, banks will need to evaluate the trade-off between the negotiation costs and the gains to be had from engaging in it. In some cases, it may be better to quickly acquiesce to a renegotiation that (slightly) favors the counterparty. This will also minimize legal and reputational risk. In all cases, the clients should be approached well in advance of the transition to allow them to understand its rationale and necessity. » Establish a pricing and valuation framework for the future. The new rates that replace EONIA and EURIBOR cannot simply be plugged into the old pricing schedules. ESTER+50bps, for example, will not be the same as EONIA+50bps, and the revised EURIBOR is unlikely to have the same term structure as the old one. So banks will need to create new pricing yield curves, adapting their margin spreads to the new reference rates to ensure no loss of margin. Yields curves are typically used in many pricing, valuation and risk management models across a bank. To ensure that nothing falls through the cracks, the transition team should make an inventory of all the models in the bank that employ yield curves based on EONIA and EURIBOR. Many of these models may need to be recalibrated to the new yield curves and, potentially, validated by the local regulator. The changes may also need to be reflected in the specification of pricing and risk limits for frontline staff. The implications for hedge accounting relationships, OCI and capital must be assessed and potential mitigation plans formulated. Banks should take advantage of the opportunity created by these required changes to improve their overall pricing framework. Pricing should be harmonized so that a consistent logic is applied across the bank, even when the important drivers of the optimal price differ between products and lines of business. This harmonization should be delivered by a single central pricing engine that uses modern technology, such as micro services and cloud computing, to store the necessary data and make the pricing model easily accessible to front line staff. Where discretionary pricing is required, the technology should also make simulation tools available to the relevant staff. The efficiency gains and improved price realization delivered by this technology will more than compensate for the investment cost. Master Complexity and Get Ready for the Future The work required to transition to the new rates will be technical and detailed. Banks must protect themselves from the downsides of a badly managed transition. But program managers must also avoid getting lost in the details. As the replacement of reference rate touches so many elements of a bank’s front-to-back operating model, it overlaps with many other ongoing or planned projects. In the worst case, these other initiatives will need to be reprioritized to free up budget and resources for the reference rate program. In the best case, however, synergies of up to 20 percent can be achieved by coordinating this. Successfully executing a large program of overlapping project initiatives requires central management that adheres to six guiding principles. (See Exhibit 2.) The transition to new reference rates is not a strategic decision by any bank. It is a consequence of shifts in both market liquidity and increased regulatory engagement. Nevertheless, if banks use the transitions as an “imposed opportunity”, they can not only minimize the financial and operational risks but greatly improve their pricing systems, model landscape, data platform and IT infrastructure. Author Andreas Bohn is an associate director in the Frankfurt office of The Boston Consulting Group. Michael Buser is a project leader in the firm’s Frankfurt office. Bernhard Kronfellner is a principal at BCG´s Vienna office. Michele Rigoni is a project leader in BCG’s Milan office. Pascal Vogt is an associate director in the firm’s Cologne office. Volker Vonhoff is a principal in BCG’s Stuttgart office.



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