BFN3164 FINANCIAL RISK MANAGEMENT

TRIMESTER 2, 2020/2021
Lecturer: Nguyen Thi Phuong Lan

Group Assignment #1 (10 Marks)

GROUP MEMBERS

No Student Name Student ID

1 HAGLA MOHAMED ELHASSAN ABDALLA AHMED 1181301657

2 IBNAT, AKILA 1171300073

3 RIZAL RAHIMI BIN RAHMAN 1181301981

4 ALI IMRAN BIN MASURI 1181302191

5 NASRUL AMIN BIN ZAINOL RASHID 1181302494

Submission Date: 7/01/2021

Table of Contents

1.0 Introduction 2
1.1 The background and history of LIBOR 2
1.2 The reason why LIBOR needs to be replaced by the end of 2021 3
2.0 The proposed rates that will replace LIBOR after 2021 5
UNITED STATES 5
EUROPE 5
BRITAIN 6
SWITZERLAND 6
JAPAN 6
OTHER 7

3.0 Why those rates mentioned in (2) are believed to be better than LIBOR 8
4.0 What are the challenges for banks when a newly proposed rate is replacing
LIBOR after 2021? 11

5.0 References 14

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1.0 Introduction
1.1 The background and history of LIBOR

The London Interbank Offered Rate (LIBOR) is a global bank benchmark for their interest
rate charges to lend to one another in the international interbank market for all of the
short-term loans. Libor existed and started to be important back 30 years ago when all of the
banks realized that they require a benchmark to calculate prices at a fair price for all of the
bank-to-bank services in the 1980s. The first time when LIBOR method was executed was
during New Year’s Day in 1986, although, at the time, the influence of LIBOR was not that
big. As of today, LIBOR is considered one of the most reliable financing tools and as a
benchmark for banks nowadays. Libor also serves as a globally accepted key benchmark
interest rate that indicates borrowing costs between banks. Until then, the bank and the
customers were using the barter system which resulted in bargaining between banks on
numerous types of loans. The rate is calculated and will continue to be published each day by
the Intercontinental Exchange (ICE)
This LIBOR system which measures for all of the average estimates of interest rates proposed
by all of the participating banks was able to not only perform well during the financial
uncertainty but at the same time, it can be considered as an indication for the nation’s
financial health in general. LIBOR can also be the basis for loan consumers in their
respective countries around the world. In other words, it impacts the consumers just as much
impact as financial institutions. Libor is a very good benchmark in a sense where it can help
banks to set up the interest rates on various credit products such as credit cards, car loans, and
adjustable-rate mortgages fluctuate based on the interbank rate. This change in rate helps
determine the ease of borrowing between banks and consumers.

It involves all of the interest rates charged between banks in terms of loans and also deciding
for the bank to charge for the interest rate on a range of financial instruments, including
bonds, savings accounts, derivatives, mortgages, and student loans.

The British Bankers’ Association (BBA) is the primary trade association that is involved in
the financial welfare of the UK. BBA’s responsibility is to regulate the financial affairs of the
UK and also set the LIBOR. BBA also will govern the LIBOR and at the same time will take
care of the LIBOR from misuse of the banks to take advantage of others like for example
charging extra interest rates etc. There have been a lot of cases about banks misuse the
LIBOR which had already been into court cases.

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1.2 The reason why LIBOR needs to be replaced by the end of 2021

The reason why LIBOR needs to be replaced by the end of 2021 is that the Financial Conduct
Authority (FCA) of the United Kingdom has determined that the way LIBOR is measured in
practice means that stable interest rate benchmarks are no longer compliant with globally
agreed standards. As such, the FCA announced in 2017 its desire to stop compelling banks
from submitting the rates needed after the end of 2021 to measure LIBOR. The underlying
demand from which LIBOR is extracted is no longer used in large amounts. Consequently,
the bank’s applications to retain the LIBOR rate are mostly (in certain parts) based on
expert’s opinions instead of actual transactions.

The LIBOR Scandal was a widely publicized system whereby bankers worked with one
another at many large financial institutions to exploit the LIBOR. In the financial industry,
the scandal planted mistrust and led to a surge of penalties, litigation, and regulatory actions.
The scandal included several high-profile financial institutions including Barclays (BCS),
Citigroup, JP Morgan Chase (JPM), Deutsche Bank (DB), and Royal Bank of Scotland
(RBS). Due to the central role that LIBOR plays in global finance; the LIBOR scandal was
notable. From the interest rates that large companies are paying for loans to the rates that
individual consumers will pay for housing loans or student loans, the LIBOR is applicable to
assess anything. It is used in derivative pricing as well. Therefore, when the LIBOR can be
manipulated, the investors in question indirectly triggered a wave of mispriced financial
assets across the whole global financial system. Justifiably, this will lead to a massive public
uproar, as parties across the globe questioned if they could have been financially affected.

At the same time, the Secured Overnight Financing Rate (SOFR) is the primary substitution
for the LIBOR dollar which encompasses approximately $200 trillion of securities. In
January 2019, LIBOR’s administrator, ICE Benchmark Administrator, launched its Bank
Yield Index as a possible substitute for LIBOR-linked lending activity. The regulators favor
16 SOFR instead of LIBOR due to the index belonginned by a massive amount of the trade
whereby more than $1 trillion on most days by the SOFR compared to an approximately
$500 million for the three-month LIBOR currency. This will lead to less vulnerability to
corruption and a clearer representation of the cost of capital. The Bank Yield Index of the
IBA has several tenors and the credit component SOFR lacks, whereby it implies that when
they lend, it represents the credit risk of banks.

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There will be substantial costs and uncertainties for financial companies in the move from
LIBOR. Payments under contracts reflecting new rates would vary from those according to
LIBOR, as the suggested alternative rates are measured differently. The transformation would
affect the business risk profiles of companies, involving modifications to risk models,
valuation instruments, product design and hedging strategies. Even though products
referencing it remain in place, LIBOR can become unavailable. Usually, these contracts
contain “fall-back provisions” outlining contract conditions in the event that LIBOR is
unavailable. If as imagined when the contracts were written, the time of unavailability is
limited, the resulting losses and gains are acceptable. But if fall-back terms are used for the
remainder of the contract’s life, the economic effect is likely to be substantial, with a winner
on one hand and a loser on the other.

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2.0 The proposed rates that will replace LIBOR after 2021

The London interbank offered rate has helped determine borrowing costs around the world
for about 50 years, ranging from student loans and mortgages to interest-rate swaps and
collateralized loan obligations. In the aftermath of the financial crisis of 2008, regulators
found that banks trusted to set rates that underpin hundreds of trillions of dollars in financial
assets had manipulated them to their advantage. For the past three years, policymakers
around the globe have been developing new benchmarks to replace Libor by the end of 2021.
The challenge has been to maintain Libor’s accessibility and functionality with a replacement
that’s more trustworthy.

Here is a list of some of the alternative benchmarks designed to replace Libor:

UNITED STATES

Name: Secured Overnight Financing Rate (Sofr)

The Federal Reserve is championing the Secured Overnight Financing Rate to replace dollar
Libor, which underpins roughly $200 trillion of securities. SOFR is different from Libor in
three key respects: It’s based on real transactions, not just bank quotes; it provides only an
overnight rate, whereas Libor offers rates for seven maturities ranging from one day to one
year; and it’s a secured rate, derived from repurchase agreement transactions that are
collateralized by U.S. Treasuries. Regulators prefer SOFR because a vast amount of trading
underpins the benchmark—more than $1 trillion on most days, vs. an estimated $500 million
for three-month dollar LIBOR. That makes it a truer reflection of the cost of capital and less
susceptible to corruption.

EUROPE

Name: Euro short-term rate (Estr)

The European Central Bank started publishing Estr on Oct. 2, replacing Eonia which like
Libor was based on quotes from banks and which will disappear at the end of 2021. Belgian
regulators in July approved the reform of the separate Euribor benchmark for longer-term
contracts. ESTR draws on money-market transactions that show the overnight unsecured
borrowing costs of euro-area lenders. It’s underpinned by an average of about 500 daily deals
totaling roughly €40 billion, according to recent figures compiled by the European Central

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Bank, and has a broad range of participants that can include pension funds and insurance
companies.

BRITAIN

Name: Sterling overnight index average (Sonia)

The U.K.’s Libor replacement, the Sterling Overnight Index Average, has been around since
1997. Sonia, as it’s known, has been overseen by the Bank of England since 2016 and made
its debut in a reformed version in 2018. Like ESTR, Sonia measures the rate paid on
unsecured overnight funds. The reformed gauge includes transactions negotiated bilaterally
between banks as well as broker-intermediated loans. Other modifications included
adjustments to the averaging methodology and a new publication time to give the BOE more
time to process transactions. It’s used to value about £30 trillion ($39 trillion) of trades each
year, according to the BOE.

SWITZERLAND

Name: Swiss average rate overnight (Saron)

Saron, the Swiss Average Rate Overnight, is similar to SOFR in that it’s based on overnight
trades, but in the Swiss franc-denominated repurchase agreement market. Saron is based
specifically on transactions between financial institutions. While banks are already selling
Saron-based mortgages, other credit products are still overwhelmingly priced off of LIBOR.

Until 2019, the Swiss National Bank used Libor to guide the country’s monetary policy. The
central bank switched last June to a new benchmark—the SNB policy rate. The bank now
implements monetary policy by managing liquidity in Swiss money markets to steer Saron
and keep it in line with its benchmark, which at -0.75% is the lowest in the world.

JAPAN

Name: Tokyo overnight average rate (Tonar)

The central bank is leaning on two alternatives to yen Libor, Tibor, and Tonar, as it looks to
transition about $30 trillion of assets referencing the beleaguered benchmark. Tonar is
Japan’s short-term alternative based on transactions in the uncollateralized overnight

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borrowing market. Regulators are seeking to develop a term structure based on market data
for overnight index swaps, which use Tonar as the floating leg.

OTHER

Libor is calculated for just five major currencies—the dollar, euro, pound, Swiss franc, and
yen. Still, other countries are reforming their Libor-like reference rates.

- Financial-services companies in Singapore are set to adopt the Singapore Overnight Rate
Average, which is replacing the Libor-based Singapore-Dollar Swap Offer Rate, which
underpins some S$3.5 trillion ($2.5 trillion) of derivative products.

- The Libor rate for Australian dollars has been discontinued and replaced by the bank bill
swap rate, commonly known as BBSW, which is referenced in about A$18 trillion ($13
trillion) of transactions.

- The Hong Kong Dollar Overnight Index Average, or Honia, has been proposed by the
Treasury Markets Association as an alternative to the local Hong Kong Interbank Offered
Rate, known as Hibor.

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3.0 Why those rates mentioned in (2) are believed to be better than
LIBOR

In 2017, the Financial Conduct Authority announced that the professional bodies will not
continue to apply LIBOR since a lot of banks provided new proposed interest rate figures
which do not consider the rates that they could borrow. The existence of these proposed rates
led to LIBOR's distrust as an indicator for the global economy’s financial health. Hence, the
discontinuation of the LIBOR system will be finalized by the FCA at the end of 2021 since
the implementation of these alternative rates mentioned.

a. United States of America - Secured Overnight Financing Rate (SOFR)

The Secured Overnight Rate, SOFR is the first crucial rate in the derivatives market. The
interest rate swaps that corporations apply to use to deal with interest rate risk and control any
changes in borrowing costs.
The interest rate swaps are agreements between two parties in exchanging the fixed-rate
interest payments into floating-rate interest payments. Based on SOFR’s policy when one
party initially makes an agreement to pay a fixed interest rate, then the other party pays back
with a floating interest rate.

b. United Kingdom - Sterling Overnight Index Rate (SONIA)

The Sterling Overnight Index Average (SONIA) is a British alternative interest rate that is
more active and liquid especially when it comes to cash and derivatives.
The reason that SONIA is more preferable to be implemented and after LIBOR’s
discontinuation is that the sustainability of SONIA is more robust and less volatile than
LIBOR at the same time. The SONIA also explains that it is actually risk-free which does
not include severe credit risk or liquidity premiums which is essential to LIBOR’s
computation. This is because LIBOR is established with financial institutions that involve
borrowing liquidity assets to each other over long periods.

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c. Switzerland - Swiss Average Overnight Rate (SARON)

Since LIBOR functions as the rate used by banks to loan liquidity assets to other banks, the
use of the Swiss Average Overnight Rate system differs from LIBOR’s.

LIBOR is not assisted by any transactions except that it defines the agreement between
financial institutions. The difference between SARON and LIBOR is that LIBOR has lesser
transparency compared to SARON as its lack of security causes it to be exposed to
unprotected threats and leads to manipulation.

The Swiss Average Overnight Rate is the alternative rate from Switzerland which their
system obeys based on daily transactions. The more they focus and are aware of the daily
transactions, the alternative rate would likely be more transparent and their securities will be
more protected.

It takes a lot of obstacles to make loans or mortgages based on the LIBOR rate system from
financial institutions. The new alternative rate that replaces LIBOR uses fixed-rate mortgages
with a period of two to three years in the short term. When financial institutions charge a
margin on SARON, debtors have the ability to estimate the conditions that are similar to
those applied to the current situation. Furthermore, a legally protected security helps debtors
of guaranteeing that they will not experience any faults with the replacement system from
LIBOR to SARON at then end of 2021

d. Japan - Tokyo Overnight Average Rate (TONA)

The Tokyo Overnight Average Rate, TONA is a Japanese alternative rate that replaces
LIBOR on a daily basis. Japanese alternative rate that mostly involves the Japanese yen, is
computed and produced on a daily basis by the Bank of Japan through a selection of
information by brokers by following transaction data. In order for TONA to replace LIBOR,
the term rates which reference TONA must be built. There several public consultations
proposed which consist of forwarding approach, historical or median approach, and spot
spread approach.

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 - Forward Approach
The forward approach is the adjustment between LIBOR and TONA which relates tenor
when the fallback is triggered. It is suitable for this approach to be applied in order to make
computation that may not be prepared or any unprotected threats that lead to manipulation
and misrepresentation in the market.

- A historical mean or median approach

The historical mean explains the adjustment that follows based on the spot between LIBOR
and TONA especially the calculation of adjustment over a certain period from five years and
above. The adjustment of this approach depends on the market which requires basic
application and verification process as well as decreasing the consequences of market
misrepresentation and manipulation.

- Spot Spread Approach

Finally, the spot spread approach is an adjustment of spot spread between LIBOR and TONA
foregoing related announcements that triggers the fallback provisions. Despite the easement
of its approach method, however, it is volatile to vulnerabilities to the financial markets.

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4.0 What are the challenges for banks when a newly proposed rate is
replacing LIBOR after 2021?

The LIBOR transition will impact both legacy (existing pre-transition) and future financial
instruments (e.g., loans, derivatives, and floating-rate notes) and will present challenges for
banks that have yet to be resolved.

As markets and regulators prepare to switch from LIBOR to a newly proposed rate, the banks
must understand the scope of the challenges they will face and act quickly to minimize the
effects of those challenges during their own LIBOR transition.

Here are some of the challenges that possible to be faced by the banks and the financial
institutions:

1. The effects of various financial risks on banks’ functions.

The banks are going to face variety of risks that will affect on the banks’ functions, which
means, the financial transactions may not run smoothly as a result of the LIBOR transition,
such as:
I. ALM risk: by using the latest reference rates, new contracts and goods would not be
economically equivalent to the old ones based on LIBOR.

II. Operational risk: ​Limited awareness of the new reference rate to be adopted by
financial institutions and financial institutions would need to update their systems,
data, models and existing processes and Risk of errors in the inclusion of derivative
contract fallback provisions.

III. Liquidity risk: ​Market adoption of ARR is difficult without market scope and
liquidity for derivatives n Impairment issues about the recoverability of cash
instrument recovery.

IV. Conduct risk: Long-dated contracts running beyond the transition to LIBOR may
expose banks to risk behavior due to informational asymmetry between counterparties

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 and banks regarding LIBOR fallback and Lack of adequate transition approval and
control mechanism.

V. Credit and market risks: ​n Derived term structure modelling is susceptible to model
risk and creates computational challenges n Derived and implied term-structure for
new reference rates will affect interest payments creating valuation differences for
existing financial products.

VI. Reputational risk: ​Due to volatility in long-term benchmark prices, there will be a
probability of legal and reputational risk that may occur.
VII. Systemic risk: Lack of clarification due to liquidity issues regarding the durability
and robustness of the alternative LIBOR rates.

VIII. Basis risk: ​Divergence in the application of fallback methodology through CCPs in a
cleared trading book of a counterparty can trigger simple risk.

IX. Litigation Risk: ​The integration into the contract of an ARR that is radically different
from a cost-of-funding based rate like LIBOR is at risk of legal consequences.

The real challenge for the banks is how to deal with these risks in order to reduce their effect
on the banks; functions.

2. New fallback language being drafted by the financial firms

While the recommended fallback language has been largely finalized by ARRC and ISDA,
there remains a possibility of conflicting results between loans and the derivatives designed
to hedge them. Because of the significance of aligning hedges with underlying risks and
removing the simple risks that would otherwise arise from an asynchronous transfer between
loans and derivatives, this poses a risk to end-users.
However, after the transition, all contracts using LIBOR would fall back to new terms, a
condition often referred to as "The Largest Corporate Action in the World." Fallback
terminology is frequently poorly worded on current contracts, requiring clarification and
improvements in contract economics. This is a challenging conversation with clients for
banks to have.

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For both legacy and new transactions, banks are highly recommended to routinely capture
and store the fallback language and confirm that the fallback language can be used by
operational processes in the case of a termination event (referred to as the 'operationalizing
fallback language').

3. Conduct risk and data complexity

Banks would require a thorough analysis of their exposure to each counterparty and of the
transition's expected economic effect on all goods and currencies. This is especially
burdensome in cases involving goods linked to various companies and sectors of the
economy.

4. Cautious about crucial contractual issues that will be affected by the transition

There are many sensitive areas that shape important elements in the financial contracts that
will be highly affected by the transformation, such as maturity dates, the position of the
company in the contract, regulating law and jurisdiction, and clauses of force majeure. There
would be broad transitional documentation criteria, which will allow for a smoother Libor
succession.

5. Managing customers who need to understand both changes to existing contracts and
the new replacement products.

With the help of industry groups, such as the UK Working Group on Sterling Risk-Free
Reference Rates, the US Committee on Alternative Reference Rates, ISDA (International
Swaps and Derivatives Association), and others, banks will be holding the responsibilities of
addressing the issue of clarifying the new changes that will be occurred after the shutdown of
LIBOR since the new updates will affect the paths of those who make the decisions.

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5.0 References

1. Fernando, Jason. “The LIBOR Scandal Definition.” ​Investopedia,​ Investopedia, 3

Dec. 2020, ​www.investopedia.com/terms/l/libor-scandal.asp​.
2. Bloomberg.com​, Bloomberg,
www.bloomberg.com/news/articles/2020-12-03/libor-replacement-race-picks-up-with
-ameribor-swap-deal-debut​.
3. White, L. (2019). ​Factbox: The global benchmarks replacing Libor.​ The U.S.
Retrieved 3 January 2021, from
https://www.reuters.com/article/us-britain-libor-transition-factbox-idUSKBN1WN0H
N
4. “The Replacement of LIBOR.” ​Santander Bank​,
www.santander.com/en/landing-pages/banco-santander-london-branch/the-replaceme
nt-of-libor​.
5. Korby, B., Shaw, W., & Harris, A. (2020, August 11). ​A Guide to the World’s New
Benchmarks After Libor​. Retrieved January 03, 2021, from
https://www.bloomberg.com/news/articles/2020-08-11/a-global-guide-to-the-new-ben
chmarks-that-will-replace-libor
6. Wyman, Oliver. ​LIBOR Transition: Replacing the World's Most Important Number,​
www.oliverwyman.com/our-expertise/insights/2018/feb/libor-rate-transition.html​.
7. Kurt, D. (2020). ​Understanding the secured overnight financing rate.​ Dec 3, 2020,
from
https://www.investopedia.com/secured-overnight-financing-rate-sofr-4683954#:~:text
=SOFR%20is%20based%20on%20transactions,than%20on%20estimated%20borrowi
ng%20rates​.
8. Dodds, A., Macleod, E., and Barrett, L. (2020). ​Better The Devil You Know? The
​ ay 6, 2020, from
Transition From LIBOR to SONIA. M
https://www.stevens-bolton.com/site/insights/briefing-notes/better-the-devil-you-kno
w-the-transition-from-libor-to-sonia
9. Saron Replaces LIBOR (n.a.) Retrieved from
https://moneypark.ch/en/mortgage/saron-replaces-libor/#:~:text=Libor%20​(the%20Lo
ndon%20Interbank%20Offered,lend%20money%20to%20other%20banks.&text=Sar

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 on%20(the%20Swiss%20Average%20Rate,is%20therefore%20considerably%20mor
e%20transparent.
10. Konishi, M. (2019).​Public consultation on appropriate choice and use of Japanese yen
interest rate benchmarks .​ ​ Nov 1, 2019, Retrieved from
https://www.investopedia.com/secured-overnight-financing-rate-sofr-4683954#:~:text=SOFT
%20is%20based%20on%20transactions,then%20on%20estimated%20borrowing%20rates​.
11. “Factbox: The Global Benchmarks Replacing Libor.” ​Reuters,​ Thomson Reuters, 8
Oct. 2019,
www.reuters.com/article/us-britain-libor-transition-factbox-idUSKBN1WN0HN​.
12. Bloomberg.com,​ Bloomberg,
www.bloomberg.com/news/articles/2020-08-11/a-global-guide-to-the-new-benchmark
s-that-will-replace-libor​.
13. “Life after LIBOR.” ​KPMG​, KPMG, 13 Apr. 2020,
home.kpmg/xx/en/home/insights/2020/04/life-after-libor.html.
14. Christy Rakoczy (n.a.) ​What Is Libor – London Interbank Offered Rate History & Scandal .
Retrieved from: ​https://www.moneycrashers.com/libor-rate-history/

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