As the end of LIBOR approaches, these 8 steps can help your bank better prepare for the transition.
In July 2017, the Financial Conduct Authority (FCA) announced that the availability and reliability of the London Interbank Offered Rate (LIBOR) beyond 2021 would not be guaranteed. In November 2020, the Intercontinental Exchange Inc. (ICE) Benchmark Administration Limited (IBA) announced it will consult on its intent to cease the publication of all non-U.S. dollar (USD) denominated LIBOR and certain USD denominated LIBOR rates immediately following the LIBOR publication on Dec. 31, 2021, and the remaining USD LIBOR settings immediately following the LIBOR publication on June 30, 2023. Concurrently with the IBA announcement, the federal banking regulators released a “Statement on LIBOR Transition” explaining that the June 30, 2023, date “would allow most legacy USD LIBOR contracts to mature before LIBOR experiences disruptions.” The statement goes on to say, “the agencies believe entering into new contracts that use USD LIBOR as a reference rate after December 31, 2021, would create safety and soundness risks and will examine bank practices accordingly.”1
Given the four-plus-year interval between the 2017 announcement and LIBOR’s phaseout, initially there seemed to be plenty of time to make the necessary changes and adapt. With the discontinuation of LIBOR now just over one year away and regulatory scrutiny on LIBOR transition increasing, many small and midsize banks find themselves behind schedule in addressing this pending change.
LIBOR is a widely used benchmark for short-term interest rates. It underpins financial transactions that the Federal Reserve has estimated total approximately $200 trillion dollars.2 Since 2013, LIBOR has been based on the submissions of a panel of large global banks and regulated by the FCA. While much rigor has been injected into the process of setting LIBOR in more recent years, for many years prior, LIBOR was plagued by scandal. Even with additional rigor preventing impropriety, other concerns with LIBOR, such as an insufficient volume of transactions in certain currencies and tenors to derive a fundamentally sound reference rate, have been common.
The absence of sufficient transaction volume led the FCA to announce in July 2017 that, while the current panel banks would voluntarily agree to sustain LIBOR until the end of 2021, the availability and stability of LIBOR as a reference rate would not and could not be guaranteed beyond that date. The FCA’s determination to provide a transition period of slightly longer than four years was grounded in the belief that selecting a date that far in advance would provide all market participants the ability to transition away from LIBOR in a “planned and orderly” manner that would also create “less risk and less expens[e].”3
LIBOR transition journey
The timeline to transition away from LIBOR of just over four years is slightly longer than the three and a half years granted to SEC filers transitioning from the incurred loss methodology of estimating allowances for loan losses to the current expected credit loss methodology (more commonly known as CECL) and the three years granted to public business entities to implement the new standard on leasing.
One critical difference between the LIBOR transition and the implementation of these other key accounting standards is a staggered adoption timeline provided by the accounting standards, with public companies adopting first and smaller, nonpublic companies adopting one to three years later. Additionally, the accounting standards are promulgated by the Financial Accounting Standards Board, which has the authority to set transition dates. In contrast, LIBOR is based on the voluntary submissions of a group of global banks and ideally is based on actual transactions conducted by those banks.
The Federal Reserve previously has noted that even the current submissions provided by the panel banks are based, to a large degree, on expert judgment as trades in certain durations and currencies are minimal to nonexistent. As more transactions shift away from LIBOR to other alternative reference rates, this issue will be exacerbated. Nothing that the FCA or any other regulatory body could do would change this dynamic. In November 2020, the federal banking regulators stated that they believe entering into new contracts that use USD LIBOR as a reference rate after Dec. 31, 2021, would create safety and soundness risks and that they will examine bank practices accordingly. It is clear banks should not take a wait-and-see approach on this important initiative.
For many institutions, 2020 was a critical year in the LIBOR transition. Limited progress had been made on transition prior to 2020, but with some banks expecting the adoption of CECL to be behind them as of Jan. 1, 2020, and others getting an additional deferral to 2023, resources devoted to implementing that standard were expected to shift to LIBOR transition. As many know, 2020 has provided banks with multiple unanticipated challenges that have drawn resources away from LIBOR transition, including shutdowns and remote working as a result of COVID-19, Paycheck Protection Program participation, and loan modifications and deferrals to assist borrowers, among other items. While LIBOR transition was always an important initiative, the shortened time span between now and the 2021 phaseout has elevated its urgency.
8 steps to transition away from LIBOR
The transition away from LIBOR involves at least eight key steps:
- Establishing a transition plan with an appropriately robust governance structure.
- Identifying all affected contracts, which could include loans, securities, debt agreements, derivatives, leases, and more.
- Adding fallback language to new contracts denominated in LIBOR to allow for a smooth transition once a replacement rate has been selected.
- Selecting a replacement rate and determining appropriate changes to credit spreads. While the Secured Overnight Financing Rate (SOFR) has been designated as the recommended alternative to LIBOR by the Alternative Reference Rates Committee,4 each institution should evaluate what alternative rate(s) would best fit their business and their borrowers. It is important to understand several differences between LIBOR and SOFR and other alternative reference rates in order to make an informed decision and minimize negative impacts on profitability, net interest margin, and interest rate sensitivity.
- Ceasing entering into new LIBOR-based contracts.
- Programming changes into models and systems to support the change.
- Modifying existing contracts and managing the customer experience.
- Assessing the accounting, tax, and financial reporting implications of the transition.
The multiphase process to transition away from LIBOR will involve different stakeholders across each bank. The necessary steps require time and thoughtful deliberations to minimize risk to customer satisfaction, net interest margin, and interest rate sensitivity, among other considerations. Institutions should continue working their plans (or establish one if they haven’t already!) to get themselves well-positioned for the end of LIBOR in its current form at the end of 2021.
1 “Statement on LIBOR Transition,” Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corp., and Office of the Comptroller of the Currency, Nov. 30, 2020, https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20201130a1.pdf
2 Randal K. Quarles, “Introductory Remarks,” Board of Governors of the Federal Reserve System, July 19, 2018, https://www.federalreserve.gov/newsevents/speech/quarles20180719a.htm
3 Andrew Bailey, “The Future of LIBOR,” Financial Conduct Authority, July 27, 2017, https://www.fca.org.uk/news/speeches/the-future-of-libor
4 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.” https://www.newyorkfed.org/arrc