Circular Letter No. CC/2020/00000061: Best Practices for Preparing Institutions for Reference Interest Rate Reforms

Circular Letter No. CC/2020/00000061 Sent to: Credit Institutions and Financial Societies. Mod. 40000375/T – 01/14 Subject: Best practices in preparing institutions for reference interest rate reforms

In June 2016, Regulation (EU) 2016/1011 of the European Parliament and of the Council1 (known as the EU Benchmark Regulation or BMR) was published, establishing a common framework to ensure that reference interest rates meet certain requirements guaranteeing their reliability and efficiency, as well as protecting consumers and investors.

As a result of the publication of this regulation, a process of reform of reference interest rates was initiated, which involved, inter alia, the transition from the Euro OverNight Index Average (EONIA) to the new short-term euro rate Euro Short-Term Rate (€STR), as well as the introduction of relevant changes at the level of the EURIBOR calculation methodology. According to the BMR, only reference rates that meet a set of specific requirements from the beginning of 2022 may be used in new contracts or financial instruments.

It should be noted that reference interest rates for other currencies are also being subject to reform by the entities responsible for their administration, or to replacement by alternative reference interest rates.

Considering the widespread use of reference interest rates in financial contracts, as well as in discounting, valuation and risk models and their importance in current business practices, it is fundamental that institutions internalize and mitigate the risks associated with these ongoing reform processes and adopt the necessary actions to ensure an adequate transition.

To this end, the European Central Bank (ECB) published on 23 July 20202 the report “Report on preparations for benchmark reforms”3, which includes a set of best practices to be followed by credit institutions in preparing for reference interest rate reforms.

This report was based on a supervisory initiative launched in 2019 to assess the state of preparedness of significant institutions to respond to said reforms. In the report “Horizontal assessment of SSM banks’ preparedness for benchmark rate reforms”4, also published on 23 July 2020, the ECB concluded that institutions, despite being aware of the complexity of the reforms and the challenges involved, were insufficiently prepared and lagging in the implementation of risk mitigation measures.

1 Regulation on indices used as reference indices in the context of financial instruments and contracts or for measuring the performance of investment funds and amending Directives 2008/48/EC and 2014/17/EU and Regulation (EU) No 596/2014 2 https://www.bankingsupervision.europa.eu/press/pr/date/2020/html/ssm.pr.200723~cba7253463.en.html 3 https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.reportpreparationsbenchmarkratereforms202007~bd86332836.en.pdf?a448bf8a795e672e5d87d01495c9d0fe 4 https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.horizontalassessmentssmbankspreparednessbenchmarkratereforms202007~a96763cb4b.en.pdf?dee821013910e0e51ca6bb1f7e71cf49

Mod. 40000375/T – 01/14

In parallel, the Bank of Portugal conducted a similar exercise among less significant credit institutions, reaching similar conclusions regarding the state of preparedness of said institutions.

Thus, the Bank of Portugal wishes to reinforce the importance of less significant credit institutions and financial societies subject to its supervision adopting timely actions to ensure an adequate transition and mitigate risks arising from reference interest rate reforms.

In particular, the Bank of Portugal recommends that institutions consider for this purpose the best practices identified by the ECB, as well as other best practices and recommendations published by relevant working groups5 in this context, weighing, if necessary, additional measures that may be necessary given the nature of each institution's exposures, taking into account proportionality criteria.

5 The Working group on risk-free-rates (https://www.ecb.europa.eu/paym/initiatives/interest_rate_benchmarks/WG_euro_risk-free_rates/html/index.en.html) has published documents with the purpose of supporting market participants in the process of transitioning reference interest rates.