Risk Managing the LIBOR Transition
Updated: Jun 5
Published December 2020
As LIBOR and other funding benchmarks are withdrawn, the industry needs a better way to calculate funding risk for each transaction and aggregate that incremental risk to legal entities. Global Valuation proposes a better approach than risk free rates, add-ons and fall-backs - which is made possible by the ability to calculate the true cost of funding risk on a not-for-profit basis quickly and accurately. This approach utilises full-life modelling of Banks' economic capital and re-hypothecated collateral, and discreet calculation of the impact of incremental trades on a full scale portfolio calculation, aggregated to legal entity.
By halting the LIBOR's publication, large volumes of fixed income securities, from loans to derivatives, will fall back to an alternative fixing reference. The initial proposal of a SOFR fall-back eliminated any degree of subjectivity but opened up funding risk. Overlaying a credit spread over SOFR is a remedy that goes in the right direction, but neither guarantees a robust hedge for funding risk nor prevents accidental wealth transfers.
To ensure robust funding risk hedges under all scenarios, we propose to complement the fall-back rate by overlaying it with periodic exchanges of Funding Valuation Adjustment (FVA) reset amounts. Our proposal accomplishes the LIBOR indexing’s mandate of transferring banks’ funding risk to counterparties more accurately and robustly than the LIBOR itself while being objective and legally robust.
We conclude that the LIBOR transition is an excellent stimulus and opportunity to improve funding strategies and, if implemented with foresight, can make the financial system more resilient and efficient.