With the publication of comprehensive capital analysis and review (CCAR) and Dodd-Frank Stress Test (DFAST) results on June 25th1 and with 16 months remaining until the retirement of LIBOR, firms should look into how CCAR submission are expected to be impacted for 2021 given the replacement of LIBOR with Alternative Reference Rates (ARRs). Banks should develop their LIBOR CCAR “transition house strategy” to include their changing risk profile as well as updating their CCAR stress testing capabilities for the LIBOR product transition.
As firms work to develop their LIBOR remediation plans surrounding their products, contracts, systems and processes—certain financial processes should also be impacted. One of these key LIBOR-related impacts includes the Q1 2020 CCAR submission to the Federal Reserve. The Federal Reserve published the revised FR Y-14A instructions on April 2, 2020 with the “… option to delay for two years an estimate of CECL’s effect on regulatory capital, relative to the incurred loss methodology’s effect on regulatory capital, followed by a three-year transition provision.”2
Firms have business as usual (BAU) processes spanning lines of business and finance groups to execute the CCAR submission. Various components and inputs are involved in a successful submission, some of which should be impacted by LIBOR and therefore require remediation. CCAR leverages the outputs of a 9-Quarter (9Q) forecast, as well as other financial inputs such as assumptions, and the use of models and/or tools. Firms embarking on a CCAR process remediation by Q1 2020 should start with those upstream components, particularly the 9Q forecast which requires model/system/data/assumption remediation of its own. So where can a firm get started? An impact assessment to determine the components requiring remediation and those that overlap between CCAR inputs such as 9Q and CCAR itself is the first step.
A plan with remediation by Q4 2020 for 9Q and CCAR components should be drafted, leveraging efficiencies identified due to the component overlap. Process remediation for 9Q and CCAR requires model and system testing/validation/implementation, external and internal input readiness, as well as assumptions refresh and scenario analysis adjustments.
Considerations for developing a CCAR Q4 2020 Remediation Plan:
LIBOR Exposure Risk Assessment – In accordance with the Federal Reserve CCAR “Principle 1: Sound foundational risk management,” a bank holding company (BHC) should be able to demonstrate its ability to measure and assess its changing risk profile and business activities during LIBOR transition and contract renegotiation.3 As a part of this, it is important for the BHC to perform their risk identification process specific to ARR products and risk exposures during transition away from LIBOR and to include liquidity challenges with legacy LIBOR products with long dated exposures.
Our view is that a CCAR remediation plan should reflect the expected product and business activity changes assessed during risk identification by the BHC and should include assumptions around the forward projections of the LIBOR dependent portfolio and changing composition over the 9Q as LIBOR is retired and new products are exchanged.
Assess Scenario Adjustments for LIBOR transition – For CCAR submission at the end of 2020 the baseline and optional alternative scenarios should include in our view the preparatory portfolio changes leading up to the cessation of LIBOR in 2021 and include key transition events, reactions and assumptions of LIBOR cessation during quarterly projections 4-9 of 2021. Firms are also encouraged to stand-up solid scenario governance across lines of business, Risk, Legal and Treasury/Finance to curate the baseline and alternative scenarios at least quarterly if not more frequently.
The base scenario narrative should be developed around the following dimensions:
- U.S. regulatory environment and guidance provided (Federal Reserve, U.S. Treasury, and Commodity Futures Trading Commission,Alternative Reference Rates Committee)
- LIBOR impacted products (derivatives, floating rate notes, adjustable rate mortgages/consumer loans, syndicated/bilateral loans, securitizations, etc.)
- The development of ARR markets (Secured Overnight Financing Rate (SOFR) product market, availability and usage of LIBOR and term rates, selection of ARR/volume, pricing for new products, timing and adoption)
- Macroeconomic environment (scenario adjustments, forecasting interest rate projections)
- Risk considerations (operational model/system readiness, financial impacts, regulatory expectations, conduct risk, etc.)
- Legal considerations (legacy contract remediation timing, enforceability by product, potential for client legal action, central counterparty action.)
Firms are also encouraged to conduct a CCAR Operational Risk Assessment to identify transition requirements along CCAR lifecycle including:
- Data: Identify LIBOR impacted data elements and their authoritative sources in the enterprise and perform data discovery and lineage for the systems and applications ecosystem. Modifications to systems and vendor technologies to support SOFR/ARR products should be mapped and integrated to the CCAR lifecycle.
- CCAR Modeling Planning: Develop Critical Path for CCAR Model Prioritization to address model development transition requirements and meeting standards and timelines for model validation.
- Assess Strategic vs Tactical Model updates for 2020 to address interim changes to portfolio during LIBOR cessation and market unknowns vs long-term modeling objectives when formal business processes are in place.
- Credit Loss Modeling: With the challenge of losing the dynamic credit spread component baked into LIBOR, firms should establish a working group to calculate credit risk at the product level for ARR products where the credit spread is not inherent in the rate, especially in stressed scenarios.
- Market Risk Models: Consider the challenges around additional basis risk which the LIBOR transition introduces. Additionally, much weight should be placed on assumptions for historical market rates as there is a limited history of time series data in the new rate market. Firms should begin to explore suitable data proxies where required.
- Pre-provision Net Revenue (PPNR) Models/Origination Models: The CCAR transition team should document a full understanding of new product objectives during LIBOR transition so that Origination models reflect the firm’s business requirements to incorporate the ARRs and a changing portfolio composition.
- Liquidity Models: As the transition progresses and LIBOR products are renegotiated to ARRs, the liquidity in LIBOR products is expected to drop in the final quarters. CCAR transition teams should consider the impact on spreads and modeling where LIBOR liquidity is reduced.
- Program Management Office and Governance to CCAR Adjustment: Given the impact of the LIBOR transition and required involvement of stakeholders across the bank, a formal change management governance within the firm’s LIBOR program is required. A strong structure for coordinating (front office, middle, validation) and the development of a Project Management Office (PMO) dashboard to escalate CCAR change requirements and risks can provide top-down messaging on 9Q and CCAR timelines to facilitate the remediation of component dependencies owned outside the Finance space.
To find out more on the topic or how Accenture can help in your LIBOR transition, please contact the authors.
- “Stress Tests and Capital Planning,” Federal Reserve System, June 25, 2020. Access at: https://www.federalreserve.gov/supervisionreg/ccar.htm.
- “Comprehensive Capital and Analysis Review and Dodd-Frank Act Stress Tests – Questions and Answers” Federal Reserve System, July 2020. Access at: https://www.federalreserve.gov/publications/files/CCAR-QAs.pdf.
- “Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice,” Federal Reserve System, August 28, 2013. Access at: https://www.federalreserve.gov/bankinforeg/stress-tests/ccar/August-2013-Introduction.htm.
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