EONIA and EURIBOR are the reference rates for financial contracts with a nominal value of more than € 150 trillion. But they are about to be replaced. The quantity of unsecured interbank lending has collapsed and, following the LIBOR price-manipulation scandal, regulators seek to reduce the role of expert judgement in setting reference rates. By January 2020, EONIA will be replaced by an entirely new short-term (overnight) reference rate, and the derivation of the EURIBOR term-rate will be significantly revised.
Because EONIA and EURIBOR are ubiquitous in contracts between banks and their counterparties, and commonly used in valuation modelling and internal transfer pricing within banks, nearly every part of the balance sheet and nearly all front-to-back processes are affected. The shifting to new reference rates presents banks not only with one-off transition costs but with significant risk. If the old rates are no longer published, existing contracts referencing them will need to be renegotiated, presenting not only direct financial risk, but also legal, conduct and reputational risks that attend such a sensitive process. Redesigning products, hedges and valuation models for use from 2020 presents the same risks. Get things wrong, and a bank’s balance sheet, legal position and reputation with customers could all be damaged.
On a stand-alone basis, the implementation effort for many banks will be comparable to IFRS 9, potentially € 50- € 100M for smaller banks to as much as € 350M for G-SIBs. To make the most of this spend, banks should use the enforced reference rate transition as an opportunity to create synergies with other regulatory or operating model initiatives, upgrading their pricing and risk management frameworks in the process, and move to a more agile and cost-efficient model landscape, data platform and IT infrastructure. Taking advantage of such synergies could reduce the cost of the combined project by up to 20 percent.
Out With the Old Rates, in With the New
Euro-denominated financial contracts – from simple mortgages to complex derivatives – rely on two main “reference rates”: the euro overnight index average (EONIA), derived from overnight unsecured interbank transactions, and the euro interbank offer rate (EURIBOR) for monthly tenors up to 12 months, based on submissions from a panel of banks. Both rates concern unsecured lending between banks. Since the financial crisis, however, transaction volumes in these markets have declined by more than 90 percent. And, following the LIBOR price-fixing scandal, reliance on expert judgement has become a point of concern for regulators. Hence the publication of a set of principles for financial benchmarks by International Organization of Securities Commissions (IOSCO), and another by the European Banking Authority (EBA) together with the European Securities Market Authority (ESMA), which specify standards of quality and independence for financial benchmarks. A review of the existing euro reference rates deemed them to be inconsistent with the specified principles. EONIA volumes are so low that it will need to be replaced, while EURIBOR needs to be revised so that it relies less on the expert judgement of a small number of panel banks. The deadline for the application of new benchmarks is January 1, 2020.
Andreas Bohn is an associate director in the Frankfurt office of The Boston Consulting Group.
Michael Buser is a project leader in the firm’s Frankfurt office.
Bernhard Kronfellner is a principal at BCG´s Vienna office.
Michele Rigoni is a project leader in BCG’s Milan office.
Pascal Vogt is an associate director in the firm’s Cologne office.
Volker Vonhoff is a principal in BCG’s Stuttgart office.
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