On November 2, 2020, the Alternative Reference Rates Committee (“ARRC”) sent a detailed memorandum (“Memorandum”) to the Board of Governors of the Federal Reserve System (“FRB”), the Federal Deposit Insurance Corporation (“FDIC”) and the Office of the Comptroller of the Currency (“OCC” and, together with the FRB and FDIC, the “Agencies”) that summarizes the ARRC’s preliminary findings and recommendations on the potential regulatory considerations with the application of current and anticipated capital and liquidity requirements in the context of the market transition from the use of the London Interbank Offered Rate (“LIBOR”) to the Secured Overnight Financing Rate (“SOFR”) as a contractual reference rate in the United States (the “Transition”).
The Memorandum notes that a key policy goal of the Transition is to reduce overall risk in the financial system. The treatment of SOFR-based exposures under prudential capital and liquidity standards during and after the Transition should recognize this policy goal and ensure that prudential treatment of these exposures does not dis-incentivize timely and voluntary transition to SOFR. In general, if the Transition were to lead to unintended increases in capital and liquidity requirements, this would be at cross-purposes with the macro-prudential goal of mitigating risk of the financial system as a whole. To that end, the Basel Committee on Banking Supervision (“BCBS”) has issued guidance in the form of FAQs (“BCBS June 2020 FAQs”) that clarify application of certain international capital and liquidity standards in light of the transitions in many of its member jurisdictions from IBORs to risk-free rates (“RFRs”).
The ARRC states in the Memorandum that it believes US regulators should similarly address these principles with respect to current US capital and liquidity regulatory requirements, as well as to future such requirements, such as quantitative impact studies of the implementation of the Fundamental Review of the Trading Book (“FRTB”) because past studies may not have included a robust pro forma analysis reflecting the impact of the Transition and because the BCBS June 2020 FAQs are not legally operative in the United States.
The 25-page Memorandum is organized into four parts:
- Part I provides background on the Transition and the actions market participants may be expected to take to help effect the Transition.
- Part II discusses the capital and liquidity considerations related to the Transition for which the ARRC currently recommends that regulators take appropriate actions to avoid potential unintended and temporary effects of the Transition on regulatory capital and liquidity requirements that may discourage a timely Transition.
- Part III discusses other general effects of the Transition on regulatory capital and liquidity requirements that the ARRC believes merit discussion and monitoring but for which the ARRC does not have a specific regulatory recommendation in this initial analysis.
- Part IV highlights how unintended increases in capital and liquidity requirements related to the Transition would ultimately increase costs to end users of products such as derivatives.
Importantly, the ARRC considered effects beyond those arising from its recommended best practices as part of its Paced Transition Plan, including an increased volume effect (e.g., higher derivative notionals due to basis risk hedging) and reduced liquidity effect (e.g., due to both LIBOR- and SOFR-referencing instruments being outstanding and reducing liquidity for each other) from the Transition, effects that are likely to directly impact current capital and liquidity requirements.
In the Memorandum, the ARRC makes recommendations related to three types of considerations:
- Model-related considerations;
- Recalibration-related considerations; and
- Amendment-related considerations.
Model-related considerations noted in the Memorandum include the comprehensive capital analysis and review (“CCAR”) process, stress testing and stress capital buffers. The ARRC recommends that the Agencies should consult with the industry to develop more streamlined model approval requirements applicable to Transition-related model changes and effective for a temporary period during the Transition, and should otherwise make reasonable accommodations for Transition-related issues that may arise in existing market risk and counterparty credit risk models that banks may rely on during the Transition. After this period, models could be revisited and assessed on an ex-post basis, which would help mitigate time and resource constraints for both banks and supervisors. The ARRC also recommends that the Agencies consult with the industry to issue guidance on (i) the use of historical proxy data published by the Federal Reserve Bank of New York for purposes of the CCAR and (ii) expectations for the impact of the Transition on financial projections under modeled stress scenarios.
The ARRC’s recalibration-related recommendations include, for implementing the FRTB in the United States, that the Agencies (i) clarify that, consistent with the BCBS June 2020 FAQs, banks be permitted during the Transition to use the new benchmark rates for expected shortfall calculations for the reduced set of risk factors in the current period, while using the old benchmark rates as proxies in the historical stress period if the new benchmark rate is not available; (ii) clarify that banks be permitted during the Transition to capitalize desks via the internal models approach of the FRTB, even if desk-level models fail back-testing or the profit and loss attribution test, if such failure was a result of the Transition, on the basis that the Transition constitutes a “major regime shift”; and (iii) issue guidance addressing the impact of the Transition under the existing market risk and counterparty credit risk capital frameworks. Similar unintended consequences could also affect the existing market risk framework. For example, stressed Value-at-Risk and the stressed Effective Expected Positive Exposure measure under the internal models methodology may be difficult to model. In particular, regulators have not yet clarified how they expect firms to proxy such time series given that in some cases RFRs did not exist during the 2008–2009 financial crisis.
Also, the ARRC recommends that the Agencies (a) provide guidance confirming that, during the Transition, the lack of liquidity of certain collateral securities and/or derivatives will not result in an increase in the standardized or modelled exposure amounts for derivatives and securities financing transactions via an extended assumed holding period or margin period of risk; (b) in conjunction with the industry, monitor whether the Transition could cause certain collateral securities to fail to meet the “readily marketable” standard for financial collateral under the collateral recognition requirements and (c) issue guidance providing that, during the Transition, supervisors can take into account anticipated increases in the liquidity of replacement instruments for purposes of assessing whether those instruments qualify as high-quality liquid assets under the liquidity coverage ratio rule.
Finally, the ARRC recommends that the FRB engage with the ARRC to discuss, and provide modifications to, the G-SIB surcharge computation and FR Y-15 reporting instructions to avoid dis-incentivizing participation by global systemically important banks (“G-SIBs”) in the Transition.
Amendment-related considerations prompted the ARRC generally to recommend that the FRB issue guidance confirming that amending an instrument from LIBOR to SOFR (i) would not call into question its grandfathered status for purposes of the total loss-absorbing capacity (“TLAC”) rule and (ii) would not trigger the need for re-approval of a contractual conversion feature. The ARRC recommends that the FRB also confirm that the TLAC rule would not prohibit using tender or exchange offers to transition the index rate of debt or equity securities.
Specifically, the clean holding company requirements in the FRB’s TLAC rule could limit some firms’ flexibility to use tender offers or exchange offers to replace debt and preferred equity securities indexed to LIBOR with securities indexed to SOFR. In connection with a tender offer or exchange offer for its own debt or equity securities, a bank holding company typically enters into binding securities contracts to repurchase securities from third-party investors. These securities contracts are qualified financial contracts (“QFCs”) for purposes of the TLAC rule and would be prohibited by the TLAC rule’s clean holding company requirements if a covered bank holding company enters into a QFC (other than a credit enhancement) directly with an unaffiliated third party. Absent clarification from the FRB, the ARRC notes that this provision of the TLAC rule could limit some holding companies’ ability to use tender offers or exchange offers to effect Transition-related transactions related to their debt and preferred equity securities.
The ARRC also recommends that the Agencies confirm that an amendment to a capital instrument to reference SOFR rather than LIBOR would not (i) be treated as a redemption and replacement for purposes of the regulatory capital rule or the CCAR or (ii) trigger a reassessment of whether the instrument has an incentive to redeem. These confirmations would be consistent with BCBS guidance regarding capital qualification of instruments amended to effectuate the Transition.
The ARRC addresses a wide array of concerns in the Memorandum that touch on almost every capital or liquidity standard. While each recommendation addresses a well-articulated concern, it remains to be seen how the industry and the Agencies will respond. In some instances, the industry may develop well-reasoned, practical conclusions that negate the need for action by the Agencies. For example, even the ARRC states that its assumption about amending an instrument from LIBOR to SOFR will not create an incentive to redeem.
However, other issues, such as excluding transition-related hedging basis swaps from the G-SIB surcharge, are likely to require intervention by the Agencies. Given the limited number of banks affected by many of these standards, and the burden of engaging in formal rulemaking, it is possible that the Agencies will act through interpretive letters, supervisory guidance and enforcement discretion. Accordingly, banks should be working with legal counsel and the trade associations to identify approaches to their issues and planning engagement strategies with the Agencies.