It Pays To Be Proactive Transitioning From LIBOR
It Pays To Be Proactive Transitioning From LIBOR
By Chuck Doyle, CTP, Founder, President and CEO, Business Capital
LIBOR is winding down and new benchmarks are emerging to take its place. In May, Bank of America and JPMorgan Chase completed the first trade of a complex derivative product using the Bloomberg Short Term Bank Yield Index, developed specifically to replace LIBOR. The impact on lenders will be significant as it has been widely used by banks to price loans and other financial instruments.
With regulators in the U.K. and U.S. indicating they expect banks to discontinue entering into new U.S. dollar denominated LIBOR contracts after December 31, 2021, banks will have to transition to a new benchmark rate, which will require them to:
- Identify their existing LIBOR exposure
- Research and select an alternative benchmark rate
- Create a spread and term structure on a par with LIBOR
- Effect the transition to the new benchmark rate across all risk areas
In 2012, it was discovered that bankers at several major financial institutions had colluded to manipulate LIBOR rates to their benefit and that the collusion might have been happening as early as 2003. This scheme resulted in the mispricing of financial contracts around the world impacting transactions such as corporate debt, mortgages, student loans and derivative trades. If a business that takes out a loan at LIBOR + 2.0%, which adjusts after the first six months to LIBOR + 2.5%, banks will initially make more money. However, they might also run the risk of borrowers moving elsewhere and higher default rates.
Regulators in the U.K. and U.S. have levied fines totaling approximately $9 billion and brought criminal charges against many of the bad actors, and the scandal has also spawned many lawsuits. As a result, public confidence in financial institutions suffered a hit, and regulators, led by the U.S. Federal Reserve and the U.K.’s Financial Conduct Authority (FCA), have stated they will only support LIBOR until the end of 2021.
The Path Forward
FCA (UK) and the New York Federal Reserve plan to move to alternate standards. In 2018, the New York Federal Reserve announced a potential LIBOR replacement called the Secured Overnight Financing Rate (SOFR)1, based on short-term loan rates in the repo market. Because there is extensive trading in repos, it is a highly accurate indicator of borrowing costs and less prone to manipulation. Its credibility is enhanced by the fact that SOFR is based on data from actual transactions versus projected borrowing rates, as was at times the case with LIBOR. On the other hand, unlike LIBOR which is a term, unsecured, forward-based lending rate, SOFR does not have an imbedded credit risk component, is backward-looking and carries an overnight rate. These variances could have significance for calculating interest and effectiveness among certain borrowers, lenders, and investors.
On March 5 of this year, regulators and industry groups made several announcements regarding the cessation of LIBOR that enables market participants to determine when their financial instruments that reference LIBOR will move to an alternative, risk-free reference rate. LIBOR settings will not be representative after these dates:
- December 31, 2021, in the case of 1-week and 2-month USD LIBOR settings and all non-USD LIBOR settings; and
- June 30, 2023, in the case of all outstanding U.S. dollar-denominated LIBOR settings.
The Alternative Reference Rates Committee (ARRC) is composed of private market participants and assembled by the Federal Reserve Board and the New York Fed to help smooth the transition from U.S. dollar-based LIBOR to a new reference rate, such as SOFR. ARRC has confirmed that the March 5 announcements constitute a “trigger” event for banks to inform customers of the need to move away from LIBOR to a different reference rate. ARRC “fallback” language allows the customer to take advantage of a streamlined amendment process away from LIBOR. Companies with loans based on LIBOR may see a rise in compliance, financial reporting, staffing, and other costs related to the transition to alternate reference rates. More specifically, the shift in rates has the potential to impact hedge accounting, debt modification and discount rates for impairment testing, lease accounting and fair valuation.
Next Steps for Lenders
We recommend that lenders carefully analyze the fallback language in the contracts they’ve written for borrowers to date, as the transition to a new rate has the potential to create considerable conduct, reputation, and legal risk. Lenders should be clear about which alternate rate they plan to use when the transition will happen and how new contracts will be priced.
Lenders must be clear with borrowers about the transition to an alternative rate
One banker added his perspective, “Given the pending transition away from LIBOR-based funding options, most banks (commercial/corporate lenders) have been diligently preparing to support customers and prospective customers with suitable market-based alternatives and even including language in their documentation to bridge the transition away from LIBOR-based funding options. Borrowers have become accustomed with the ability to take advantage of potential incremental interest savings allowed by tactically moving between Prime vs. LIBOR interest rate options. Each borrower’s view of interest rate movements tends to be unique, especially in terms of the future movement of interest rates compared to both the volume and duration of their specific funding requirements. Borrowers will rightfully expect to retain an efficient interesting funding alternative to Prime, and according to Adam Smith’s invisible hand, the banks will accommodate them. At this point, most if not all of the existing documentation now has provisions built in that will allow for an orderly transition, regardless of the ultimately accepted LIBOR replacement funding option. The banks will, reluctantly or enthusiastically, continue to ensure their customers have the opportunity to manage their interest costs based on upon both their unique circumstances and market expectations.”
As lenders continue to chart a new course to transition away from LIBOR, they should minimize the impact on borrower relationships by:
- Creating a dedicated team within their institutions focusing on how to achieve a smooth transition to an alternate reference rate,
- Provide an ongoing stream of information to keep borrowers current on the latest developments and how the bank is handling issues related to the shift,
- Update borrowers as soon as possible about how the bank plans to update contracts and address specific issues, such as loan agreements that don’t include a provision for moving away from LIBOR.
The transition from LIBOR is a “measure twice, cut once” moment. Financial institutions that research their options carefully, act early and decisively to complete the transition and communicate effectively with their borrowers have the potential to improve relationships with their existing clients and potentially gain new ones, while institutions that respond less proactively will likely suffer client turnover and damage to their reputations.
Footnote: 1 https://www.newyorkfed.org/markets/reference-rates/sofr
About the Author
Chuck Doyle, CTP, is Founder, President and CEO of BizCap (Business Capital since 2002). BizCap delivers the best available cost of capital and industry leading structure to middle-market and lower middle-market companies seeking innovative financial strategies. The Company’s experience and long-standing network of high-level relationships with capital providers across a variety of disciplines allows the firm to efficiently deliver solutions for clients, particularly when they need immediate liquidity at a time when conventional sources of funding may be challenging or unobtainable.