Why Are Regulators Eager to Replace LIBOR as the Interest Rate Benchmark? When Do We Believe the Transition Will Take Place?
In April 2008, during the credit crisis, a Wall Street Journal article detailed a nearly 20-year conspiracy by some banks to falsely inflate/deflate their submitted rates to profit on the misinformation. This prompted multiple investigations by national legislatures and central banks, as well as billions of dollars in fines, and dozens of lawsuits and settlements. As a result, member banks became reluctant to continue making London Interbank Offered Rate (LIBOR) submissions, resulting in the watering down of LIBOR as a robust benchmark interest rate. So, in July of 2017, the Financial Conduct Authority (FCA) announced that by the end of 2021, it would “no longer be necessary for the FCA to persuade or compel banks to submit LIBOR.”
Global regulators are eager to find a suitable replacement for LIBOR that can serve as a benchmark interest rate across all major currencies, specifically those supported by a substantial volume of underlying transactions and is resistant to illegal manipulation. This switch needs to take place before the FCA LIBOR mandate expires so as not to risk dramatically destabilizing the global economy.
2.What Business Impact Will the Change of Benchmark Have?
Though LIBOR-linked transaction volumes are slowly declining, they remain interwoven into capital markets, with over $200 trillion underpinning financial contracts in the U.S. alone.
As institutions plan to transition from LIBOR, they will need to consider several pressing issues to ensure a smooth conversion:
Where does LIBOR hide? LIBOR can reside almost anywhere inside a firm’s balance sheet. Common locations are securities, loans, borrowings, and various derivative contracts. However, it is also a feature of lines of credit, trust-preferred equity, and even leases. Therefore, one of the first steps is to understand where inside your institution you have LIBOR-based exposures.
What to replace it with: No perfect benchmark replacement for LIBOR currently exists. Although a preferred U.S. alternative has been proposed, the Secured Overnight Funding Rate (SOFR), it currently has major differences from the current index. Specifically, it is a rate associated with repurchase agreement borrowing, which is secured by highly rated collateral versus the unsecured nature of LIBOR. Therefore, everything being equal, SOFR rates should be less than LIBOR. Also, SOFR is currently only an overnight rate, whereas LIBOR has seven different maturities (ranging from overnight to 12 months). Other alternatives to SOFR have also emerged, the most prominent of which is AMERIBOR.
When to replace it: Given that there is no perfect replacement currently, companies need to be very strategic as to how they look to replace LIBOR. And replacement really takes two forms — one related to new contracts that are entered into between now and 2022, and the other related to legacy contracts that extend beyond the anticipated sunset date. Two immediate considerations are whether the institution continues to enter into new LIBOR-based transactions (especially those that extend into 2022) and, if so, what type of fallback language is included within these new contracts.
Understanding the value transfer: Once LIBOR is no longer available, there will be an inevitable economic value transfer from one party to the agreement to another, as there is almost universal certainty that the replacement rate will not equal LIBOR at the sunset date. There are several concerns with this — the most significant being that parties will delay their transition plans, strategy, and execution until they have a better idea of how the economics will sort out. A second concern is that transition timing will be gamed by institutions to maximize positive economics. And a third worry is that although for large institutions the economics might net to a relatively modest amount, the value transfer (especially if negative) could be more pronounced for a bank’s customers, especially small- and medium-sized businesses and consumers.
3.What Alternative Benchmarks Are Being Considered by the Industry — Pros and Cons of Each Replacement? Is There a One-Size-Fits-All Alternative?
While the SOFR is the recommended alternative to LIBOR selected by the U.S. Federal Reserve’s Alternative Reference Rates Committee (ARRC) and is likely to be the option most widely adopted by financial institutions, it is not a perfect solution.
As previously mentioned, it represents a rate on secured borrowing/lending versus the unsecured nature of LIBOR. Also, SOFR currently has only an overnight rate, whereas there is a range of maturities for LIBOR, the most common of which is the one-month tenor. On the plus side, SOFR is backed by a deep pool of daily transaction volume. On the negative side, SOFR has tended to be more volatile than LIBOR, especially at quarter-end when global systemically important banks change their repo market activity to better manage capital levels.
Although large banks are very familiar with SOFR, regional and medium-sized institutions do not use the repo market to the same extent. Therefore, SOFR is viewed as being more of a capital markets/big bank rate. This perceived bias is accentuated by the fact there are no regional or small banks on the ARRC.
A leading alternative to SOFR is AMERIBOR. Many regional and smaller banks are starting to conduct interbank lending on the Chicago-based American Financial Exchange. So, like SOFR, AMERIBOR is transaction-based and, like LIBOR, is an unsecured rate. Also, a big plus is it tends to avoid the quarter-end volatility experienced by SOFR. However, transaction volume is not as deep as SOFR and the larger banks/ARRC have not given it as much consideration. Nevertheless, it could wind up being a better replacement rate (as many midsized institutions feel it more adequately reflects their cost of funds), especially if more maturities develop and transaction volumes increase.
Due to the multiple options available, banks will need to closely monitor developments of different alternative rates and then assess the costs and benefits of each alternative to determine which most adequately suits their needs.
4.With the LIBOR Conversation Primarily Focused on Capital Markets, Are There Implications to the Consumer Loan Market?
Absolutely, many variable-rate consumer loans are currently indexed to LIBOR including adjustable-rate mortgages, home equity loans, and student loans. Also, many small businesses have loans and lines of credit that are referenced to LIBOR. Further, many of these loans extend well beyond 2021, and many of the related loan documents do not contemplate a change in benchmark rate. Therefore, financial institutions should start to assess the risk profile of their consumer and small business portfolio, especially as it relates to positions that extend beyond the anticipated sunset date with no fallback language. Likewise, fallback language should begin to be incorporated into new underwritings.
Another consideration for consumer and small business loans involves developing a communication strategy for customers. Most borrowers have no idea that the benchmark on their loan is scheduled to go away and that their payment may be materially impacted by any change. Financial institutions will need to carefully consider cases where value is transferred away from the consumer, especially in today’s heightened regulatory enforcement environment.
5.How Should Financial Institutions Best Plan for the Likely Demise of Libor and Avoid Playing Catch-Up? Why Should Governance Be a Key Component to This Plan?
To be fully prepared for the LIBOR transition, financial institutions should begin assessing areas of risk exposure and developing action plans for each identified risk. LIBOR should become a standing topic to be addressed at Asset-Liability Committee meetings and regularly at board meetings. Financial institutions should also start to budget funds for this effort.
With the transition impacting a broad cross section of business lines, it will also be vital to establish centralized governance/program management over the initiative. Equally important, this process must have executive management oversight and buy-in from all impacted business areas. Guidehouse believes the following segments should be key areas of focus: Treasury, Risk/Modeling, Accounting, Operations, and Legal.
John Fisk, chief executive of the Office of Finance for the Federal Home Loan Banks, said that it is imperative that banks begin to assess their vulnerabilities and figure out how they intend to navigate the changes — and the sooner the better.
Now is the time to begin planning for the move away from LIBOR. Although much uncertainty exists, it should not be an excuse to avoid taking steps currently. Regulators in the UK are already asking entities for their post-LIBOR plans. That will soon happen in the U.S., as well. Taking steps now will lead to a more measured and strategic conversion that limits your institution’s financial risk.
Additional contributors: Daniel Fleishman, Ryan Brush, and Brian Karp.