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LIBOR replacement rates and contract management imperatives

Mandi Simpson, Doug Kerwin, Patrick Vernon
3/8/2021
LIBOR replacement rates and contract management

Whether SOFR or an alternative rate is selected as a replacement for LIBOR, before the clock strikes midnight to end 2021, your bank will want to be positioned for transition.

Background

The discontinuation of the London Interbank Offered Rate (LIBOR) will have far-reaching effects on contracts in the financial industry, ranging from standard loan contracts to complex derivatives and debt transactions. The first article in our LIBOR transition series, “The End (of LIBOR) Is Near. Is Your Bank Ready to Transition?,” discusses the background for this change and outlines steps banks can take to prepare. The second article, “Need a LIBOR Transition Plan? We Can Help,” provides a framework for comprehensive transition planning. This article targets executing on key items in the transition plan, such as LIBOR alternative rate analysis and selection and contract management imperatives.

Selecting the best LIBOR replacement rate

Many banks are considering a move to a secured rate, such as the Secured Overnight Financing Rate (SOFR). SOFR contrasts with LIBOR, which is an unsecured rate incorporating the notion of credit risk. LIBOR is a forward-looking rate published for different tenures that incorporates a term premium to capture credit risk exposure over that defined time horizon; SOFR is a backward-looking overnight rate based on actual transactions.

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While SOFR has been designated as the recommended alternative to LIBOR by the Alternative Reference Rates Committee (ARRC),1 the federal banking agencies issued a statement2 in November 2020 reiterating that they do not endorse a specific LIBOR replacement rate. They acknowledge each bank’s “funding models differ” and “it is appropriate for banks to select suitable replacement rates for LIBOR that are most appropriate given their specific circumstances.” Additionally, while the ARRC’s Paced Transition Plan contemplates development of term SOFR rates,3 as of the date of this publication, that has not yet been done.

Selecting a LIBOR replacement rate is an important decision for any bank with a material exposure to LIBOR and should be made thoughtfully. The onus is on each bank to evaluate alternatives that best fit its business and borrowers. It is possible that diverse borrower and loan profiles will result in multiple LIBOR replacement rates being used at the same bank. Failure to perform the appropriate level of due diligence on replacement rate selection could negatively affect borrower satisfaction, as well as profitability, net interest margin, and interest rate sensitivity.

For example, not all interest rates respond congruently to macroeconomic events. A look at historical rates of LIBOR, the Wall Street Journal prime rate, SOFR, the American interbank offered rate (Ameribor), Treasury rates, and other potential alternative rates demonstrates that while these rates typically move in coordinated fashion, the magnitude of movement and direction of the movement is not always in lockstep. A robust analysis to forecast net interest income and interest rate sensitivity under varying rate structures, measuring expected impact under current LIBOR forward curves against scenarios projecting the impact of alternative rates, should be a part of every bank’s transition plan. The process also can assist in selecting any credit and term adjustment factors that might be needed.

Asset-liability models might allow banks to complete the assessment. Alternatively, Crowe can assist with this assessment using proprietary models built for projecting cash flows under alternative scenarios. 

Identifying all affected contracts

To assess LIBOR exposure, banks should identify and inventory all contracts containing references to LIBOR. This exercise could include an extensive catalog of contracts from loans, derivatives, bonds, debt, both lessor and lessee leases, and securitizations, among others. The inventory should quantify the contractual exposure both in dollars and in units. Further, as there are a variety of tenors of LIBOR with different notes assigned different tenors, banks should document and understand each of these variables. Where applicable, banks should similarly document vintages and product types with fallback language already adequate for the purposes of the transition.

Contractual fallback language

Fallback language refers to contractual terms that describe events that would trigger changes between reference rate indices, the replacement index itself, and any spread adjustment to align the new index with LIBOR. The shift away from LIBOR generally has not been considered in contract negotiations between market participants, and respective fallback language often has been either omitted or is otherwise insufficient. Contracts that do not incorporate robust fallback language could lead to uncertain business outcomes and substandard customer service.

To assist in this effort, guidance on specific fallback language has been made available by the ARRC4 for certain common loan and financial instruments. Similarly, International Swaps and Derivatives Association (ISDA) has published fallback language guidance for contracts tied to interest rate derivatives as indicated in "IBOR Fallbacks Supplement" and "IBOR Fallbacks Protocol."5

Communication and customer service

Individual borrowers likely have a varied levels of awareness of LIBOR’s demise. Even borrowers who are aware that LIBOR is going away may not have grasped the impact of any fallback language in their contract or how the change may affect their loan payment and interest expense. To thrive on the customer experience front, it is imperative that banks develop and implement dynamic strategies to educate and communicate with customers. Creating clear and conspicuous notifications and providing those communications on a fair and equitable basis is also important from the perspective of consumer compliance. The Consumer Financial Protection Bureau FAQs might be a helpful resource for banks to consider.6

Ultimately, banks should plan carefully and communicate clearly to avoid minimizing the hard work associated with the move away from LIBOR.

On-demand webinar: Libor is going away. Are you prepared?
Prepare for the global phaseout of LIBOR as a benchmark interest rate.

1 Per the Federal Reserve Bank of New York, “The Alternative Reference Rates Committee (ARRC) is a group of private-market participants convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition from U.S. dollar (USD) LIBOR to a more robust reference rate, its recommended alternative, the Secured Overnight Financing Rate (SOFR). The ARRC is comprised of a diverse set of private-sector entities that have an important presence in markets affected by USD LIBOR and a wide array of official-sector entities, including banking and financial sector regulators, as ex-officio members.” “Alternative Reference Rates Committee,” Alternative Rates Reference Committee, https://www.newyorkfed.org/arrc
2 “LIBOR Transition: Interagency Statement on Reference Rates for Loans,” Office of the Comptroller of the Currency, OCC Bulletin 2020-98, Nov. 6, 2020, https://www.occ.gov/news-issuances/bulletins/2020/bulletin-2020-98.html
3 “Transition from LIBOR,” Alternative Rates Reference Committee, https://www.newyorkfed.org/arrc/sofr-transition 
4 “Fallback Contract Language,” Alternative Reference Rates Committee, https://www.newyorkfed.org/arrc/fallbacks-contract-language
5 “ISDA Launches Fallbacks Supplement and Protocol,” International Swaps and Derivatives Association, Oct. 23, 2020, https://www.isda.org/2020/10/23/isda-launches-ibor-fallbacks-supplement-and-protocol/
6 “CFPB Takes Steps to Facilitate LIBOR Transition,” Consumer Financial Protection Bureau, June 4, 2020, https://www.consumerfinance.gov/about-us/newsroom/cfpb-facilitates-libor-transition/

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Mandi Simpson
Mandi Simpson
Partner
Doug Kerwin
Doug Kerwin
Patrick Venon
Patrick Vernon