It’s Not About the Money – Conduct Risk in the LIBOR Transition
Few scandals have hurt the reputation of the banking industry as severely as the manipulation of the benchmark interest rate LIBOR. This behaviour damaged the integrity of LIBOR to the point where trust could not be restored, and complete cessation of the rate was deemed the only solution. Thus, regulators have mandated that LIBOR, the main interbank lending rate for 40 years, will not continue after 2021 and will be replaced with alternative ‘risk-free’ reference rates (e.g. SONIA for the sterling market). This will result in a fundamental change to the day-to-day operation of financial systems.
The industry is now undergoing a challenging transition period and attempting to control the risks arising from it. Whilst the focus of many market participants has been on protecting financial value and solving operational issues, they should be vigilant that another significant risk (and arguably a major cause of the LIBOR transition) has the potential to materialise throughout the transition process: conduct risk
The FCA has made their expectations clear: firms should be proactively managing this risk and be able to demonstrate and evidence that they have taken reasonable steps to treat customers fairly throughout the transition. Failure to do this could result in regulatory censure, penalties and reputational impacts. The FCA doesn’t make empty threats in this regard – the sum of fines issued in the first 6 months of 2020 stands at £104,717,600, the majority directly related to the unfair treatment of customers.
Where will Conduct Risks arise?
Despite the ongoing efforts of industry bodies to reach consensus on defining a fair replacement rate for cash products, such as loans and mortgages, firms must ultimately determine their own approach to removing their dependencies on LIBOR. The same applies to conduct risk management during the transition. Firms need to proactively identify conduct risks and be confident they can manage them to the satisfaction of the regulator, and importantly, evidence fair treatment without being provided any detailed guidance or specific standards.
Conduct risk will primarily arise when transitioning existing contracts linked to LIBOR, as there is potential for value-transfer to occur due to the difference between LIBOR and the new reference rate which could leave clients worse-off as a result (‘basis risk’). Conduct risk crystallises if clients are transferred to unfair rates or inferior contractual terms, or if their products become unsuitable or do not perform as expected. Risk also arises if clients perceive they are being mistreated by their bank, regardless of the economic impact, if there is a lack of transparency in the process or they feel they are being forced to change rates or conditions without adequate options. Firms need a defined approach to managing these scenarios and a front office that can deal with them in practice.
As the cessation of LIBOR draws nearer, there is a good argument for no longer issuing new business linked to LIBOR if it matures beyond the rate’s end date and will need to be transitioned. Particularly when dealing with retail clients, communications need to be incredibly clear that the interest rate will change and how, and firms need to be confident they have made these clients fully aware of any risks and impacts to them. Can firms have confidence that all products will continue to perform as customers have been led to expect and meet their needs post-transition? The decision is looming on whether the financial returns of issuing LIBOR-linked products are worth the increasing conduct risk.
Communications, Fallback Language and Conduct Risk
An overarching concern is the risk of unclear or misleading communications, particularly relating to contractual terms, new rates, risks and timelines. Firms should not delay client engagement in order to give clients enough time to assess their options and make informed decisions, nor should they avoid discussions for fear of causing confusion or accidentally providing advice.
Firms need to ensure that fallback language (the clauses dictating what happens to the contract when LIBOR ends), within existing contracts is fit for purpose and does not result in value transfer to the detriment of the client. However, relying purely on fallback provisions does not constitute robust conduct risk management. For consumer contracts, new or updated fallback provisions need to be fair under the Consumer Rights Act 2015 and, ideally, supplemented by supporting communications explaining how these clauses work in practice. Firms generally need to go a lot further than updating their contracts to fit legal standards in order to demonstrate ‘reasonable steps’ to treat customers fairly.
Successful Conduct Risk Management
Although technical risk identification and mitigation is required, firms who really succeed in conduct risk management embed a client-centric view into their culture and operations. The following key principles should underpin any LIBOR transition approach:
- Understand your client. Successful mitigation of conduct risk hinges on understanding the varying needs, level of sophistication and understanding of the transition your client base has. Conduct risk presents a greater challenge for retail clients, including small and medium enterprises (SMEs), High Net Worth Individuals, and vulnerable clients who will be relying on firms to direct them through the transition. More sophisticated clients will also benefit from timely, clear and transparent communications, given the reputational and commercial benefits of opening the LIBOR conversation as soon as possible.
- Communicate. Strong and early client communication is essential to mitigating potential conduct risks. Firms must deploy a comprehensive communication strategy that ensures customers understand how fallback provisions are expected to operate and what risks are associated with LIBOR transition. Clients must have enough time and information to assess their options. Bringing front office staff on the journey and educating them on how to discuss the implications of LIBOR transition with their clients, deal with queries and complaints will help ensure that customers receive a clear and consistent message.
- Govern proactively and with accountability. Regulators are expecting hands-on involvement by Senior Management to ensure firms take accountability for customer outcomes. For example, it is reasonable to expect firms to determine whether the proposed rate and contractual changes constitute a balanced exchange of value for retail clients. These decisions must be supported by robust governance and evidenced by records of management meetings, demonstrating that Senior Managers have acted with ‘due skill, care and diligence’ and have considered customer needs. The FCA has indicated they will take action against SMCR firms and accountable Senior Managers who fail in this regard.
- Culture is king. Poor culture can undermine the best risk management frameworks. Conduct risk is no exception. Fostering a culture that encourages individuals to take accountability for actively managing risks, including those which impact clients, goes a long way to protecting an organisation. Firmly embedding conduct risk within non-financial risk frameworks, MI and risk culture lays the best foundation for dealing with exceptional events like the LIBOR transition.
Consumers and regulators alike are watching which firms navigate the many challenges of 2020 with integrity and customer-centricity. The LIBOR transition is no exception and with expectations of fairness and transparency in financial services higher than ever, Senior Managers must not focus solely on the commercial risks and forget the conduct risks ahead of them.
At BCS Consulting we couple our industry-leading conduct risk experience, with our LIBOR transition expertise to help our clients understand and effectively manage their conduct risk exposure from the LIBOR transition.