The transition from London Inter-Bank Offered Rate (LIBOR) to alternative risk-free rates is posing a global risk in recent times. There are over $400 trillion in loans and derivative contracts globally exposed to LIBOR.
In this article, we analyze some of the key contract management, loan servicing, and documentation validation challenges of the LIBOR transition and how they were addressed by leveraging on a loan management system upgrade.
LIBOR Transition Approach
Despite global uncertainty due to COVID-19, the FCA (Financial Conduct Authority) and other regulators are proceeding ahead with the LIBOR transition. Consequently, it has been unavoidable remediation for any financial institution. Banks have numerous contracts linked to LIBOR and the same must be transitioned to the new Risk-Free Rate (RFR) regime smoothly.
To cater to the LIBOR transition, banks/financial institutions (FIs) will have to make sure that the following aspects are addressed–
The banks/FIs will have to ensure that while the loan management system has holistic capabilities like recon, payment, limit management, and accounting and control, they should also have the flexibility to adapt to the recent changes:
- If the existing loan management system is not flexible enough to accommodate the LIBOR-related changes, banks/FIs can implement an add-on suite or products that have been upgraded for the regulatory changes. Implementing the new product might pose some integration challenges to the existing ecosystem of the entity, based on the complexity of the IT landscape in lending
- While the new rates (RFR) will be fed by third-party platforms like Reuters/Bloomberg etc, integrating the loan management system (LMS) with these third-party platforms will be a challenge due to the difference in the file transfer mechanism
- There may be challenges around LMS for calculation of the interest accruals as the RFRs will be published in different time zones
- Impact of RFR loans on non-performing loans, risk's participation, and export credit agreement deals needs to be carefully assessed and appropriate strategies will have to be taken care of during the migration (including the day-to-day loan servicing post-migration)
To overcome LIBOR transition challenges related to loan servicing and contract management, market participants and regional reference rate working groups have produced a variety of functional solutions–
Look Back Days: With rates getting published daily, there are challenges around loan pricing and rate-setting mechanism in LMS for LIBOR loans. By introducing this field ‘Look Back’ for RFR, pricing/rates details of the contract can be retrieved for a defined number of backdated days for calculating the interest accruals.
Lockout Days: Earlier the rates are published daily, and the banks/customers had to wait until the loan interest date to complete the interest computation (as the accruals are amortized over a period in many of the LMS). This was posing a challenge for billing the customer in advance before the due date. By introducing the ‘Lockout Days’ field in the LMS, the same rate gets frozen before the due date (configurable). Once the rates are locked, the LMS can complete the accruals in advance, and it will be able to generate invoices/bills (and stops the daily rate refresh against the contract).
Payment Lag: By introducing this field for RFR loans, the due date for the interest payment will be adjusted after the completion of loan accruals for that specified tenure. Customers can be provided with a grace period to pay interest after loan maturity (if required).
Pricing Lag: Pricing lag is the number of days after which the rates get published in the market. In the RFR context, all RFR curves are based on actual trade volume and will be computed in arrears after the close of business or the next business day. Except for the SARON (Swiss Average Rate Overnight) rate all other rates will be published the next business day of the respective regions (start of business). SARON gets published at 6:00 PM, Switzerland local time. Earlier there was no pricing lag in the LIBOR regime. Going forward, the banks/FIs will have to take care of the pricing lag in pricing the loans by using ‘Look Back Days’ functionality
Calculation method: Earlier in the LIBOR world, the rates for a contract were considered for a defined term (and/or forward-looking). The simple interest method was used for computing the interest accruals. With the RFR regime, the contracts are for a defined term while the rates are considered on an overnight basis. Hence to compute the interest accruals, varying methods like Simple Average, compounding in arrears, daily rate compounding, will be used for each contract (case to case basis).
The HCL Experience
HCL has vast experience in implementing market-leading loan management systems for customers across the globe. HCL has been the preferred partner for various LMS implementations. As a part of the LIBOR upgrade, HCL has supported banks in the LIBOR upgrade and transition to the new RFR successfully and transition to the RFR regime before the stipulated timelines of LIBOR sunset.
As a part of the LIBOR upgrade, HCL has supported banks in the LIBOR upgrade and transition to the new RFR Successfully and transition to the RFR regime before the stipulated timelines of LIBOR sunset
HCL teams were involved in many activities:
- Performing system impact analysis, HCL teams were involved in the analysis of the user interface screen changes and license file comparison of two different LMS versions to assess the product risk.
- Requirement's validation, HCL teams facilitated review sessions to understand technical and functional configurations to adapt RFR functionalities and pricing module of the LMS to business user requirements.
- Applying agile project management concepts, the HCL team helped prioritize user stories in a sequence. Subsequently planned test case design to bring the best coverage including all boundaries of the system component.
- HCL teams were instrumental in the test plan and test scenarios/case design and execution to validate the LMS, HCL also provided functional support to achieve performance and volume testing.
- HCL played a key role in getting the business sign-off by involving in user acceptance testing support activities to resolve both technical and functional defects/clarity.
- HCL has experts in preparing automation test scripts and suits for the regression testing by analyzing periodically provide hotfixes to LMS.
- LMS landscape IT capabilities were revamped along with the LMS upgrade and our HCL teams were involved in integration testing on an ad-hoc basis to provide client flexibility and advance.
Test design and planning
As a part of the upgrade, the following types of loan transactions are:
- Non-performing loan bookings
- Risk participation bookings
- ECA (Export credit agency) bookings
- Interest mid-cycle payments
- Change transactions at the deal, facility, and outstanding
- Test cases to evaluate client custom code functionalities
Loan drawdown/Rollover automation
The bank using machine learning solutions to read mails and bank notice to classify and extract data to classify and extract data and transfer data using APIs (application programming interfaces) to complete transaction input to LMS. HCL customized the test data preparation process and created test data to meet the requirements of the RFR change.
Rates interface migration
To cater to rate feeds of LMS customized interfaces can be built to schedule the jobs. Rate interfaces and customized interest rate web services need to be tested to identify any data/connection-related defects.
Integration to multiple interfaces connecting to third-party rate feeds to be built to ensure connectivity to the LMS.
Negative rate solution
In recent times, it has been observed that base rates in the market were going below zero. To accommodate these negative rates, there is a need to test solutions using custom code and interest rate floor concept.
To cater to the RFR changes, different calculation and pricing models were customized using configurations. Few configurations were defined as alternative reference rates (ARR or RFR), default pricing options which is the most used pricing convention in the market. These pricing configurations were designed in such a way where users can modify pricing variables like a look-back pricing lag, payment lag, observation shift, etc. Testing was done to validate these RFR changes with varying scenarios.
Analyze the contract management impact to identify the impact on the existing loans. Customized plans will be made that generate a new addendum which will be mailed to the customer. Care has to be taken by way of engaging external vendors to update LIBOR to include fallback language with the implementation of new SOFR documents for the note and rider agreements.
In a typical upgrade project for LIBOR compliance, there will be several phases and each phase with its objective to enhance the product quality. It is important to implement system tests, integration tests, UAT (user acceptance testing), and DRH. The projects can be managed in an agile fashion with a higher focus on sprint planning and timeline to achieve objectives along with walkthrough sessions and formal test review meetings to achieve quality in testing. With the vast experience in LMS, HCL can help to validate the functionality and ensure that the client is meeting the regulatory requirements well ahead of the timelines.