Wednesday, July 8, 2020
The members of the Federal Financial Institutions Examination Council (FFIEC) today highlighted the risks that will result from the transition away from LIBOR, and encouraged supervised institutions to continue their efforts to transition to alternative reference rates in order to mitigate financial, legal, operational, and consumer protection risks.
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. 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.
The statement also highlights the legal and consumer compliance risks associated with inadequate fallback language, when the contractual language does not contemplate LIBOR’s permanent discontinuance. Institutions should take steps to identify and address existing contracts with inadequate fallback language to mitigate potential legal risk as well as safety and soundness risk.
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 statement identifies areas where supervisory staff will focus their reviews of LIBOR transition planning and risk mitigation efforts at regulated institutions.
Risks to Institutions
Institutions can have a variety of on- and off-balance sheet assets and contracts that reference LIBOR including derivatives, commercial and retail loans, investment securities, and securitizations. On the liability side, Federal Home Loan Bank advances; other borrowings; derivatives; and capital instruments, including subordinated notes and trust preferred securities, can reference LIBOR. Moreover, many market participants rely on LIBOR for discounting and other purposes. An institution’s risk exposure from LIBOR’s discontinuation depends on the institution’s specific circumstances. Potential risks include:
• 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.