There’s been a lot of discussion and debate about the future of the London Interbank Offering Rate (Libor). U.S. banks of every size need to be concerned and take action to mitigate the effects of life in a post-Libor World.
What is Libor and Why Is Its Termination Important?
There are close to an estimated $10 trillion dollars of loans based on Libor across the globe, which includes some interbank lending. However, the largest usage is in derivative transactions. Estimates say that on any given day about $350 trillion of outstanding derivative transactions are based on Libor. It’s also an important index used in commercial banking and is being employed in consumer and residential mortgage lending, as well.
The U.K. regulatory authorities, in conjunction with other international regulatory bodies, announced several years ago that it will no longer compel global banks to set Libor and other IBOR (non- US dollar Libor) rates after the year 2021. As a result, there is some fear that the Libor indices will no longer be available starting in 2022, or shortly thereafter. In preparation, there have been a number of committees working on possible replacements for Libor.
Here’s why that matters. If, for example, your institution originates a large Libor based 10-year commercial loan, it’s likely that at some point over that loan’s life the Libor index may no longer be available. Understanding how your bank would handle the transition off Libor is important for the long-term profitability of the loan.
Termination of Libor Can Affect All Banks
We recently spoke to a smaller community bank client that only used Prime as an index in floating rate lending and did not do any derivative transactions. They were purchasing a participation from another bank and had questions on the pricing, because the participation was based on Libor. While the administration of the loan was on the participating bank, we advised our client to review how the loan documents handled the possibility of Libor’s termination.
It is important to understand the future landscape, in case a situation like the one above happens at your bank. And if you are originating Libor based loans it is imperative that you plan for a termination event.
Planning for the Future
To prepare for the future, many financial institutions have formed an internal committee at their bank to study and make recommendations on the effects of the termination of Libor. This group should include someone from operations, treasury/finance, and lending, and they should meet regularly to develop recommendations that can be implemented soon. Delaying for the next year or two will lead to a very unprepared bank.
Your bank must also address its existing loans or derivative contracts that have terms past 2021. If you don’t have procedures in place to handle these transactions, your institution may experience losses in the future.
Tom Wipf, the chair of ARRC and a senior executive of Morgan Stanley, recently said, “It is imperative that market participants stop writing contracts that do not account for the discontinuance of LIBOR... It’s time that all market participants transition their products away from U.S. Dollar LBOR where possible and we encourage the use of SOFR now, but those that continue to use LIBOR need to make sure they have very strong fallbacks in place.”
What Your Bank’s Committee Needs to Address
After you’ve formed your bank’s committee, it is important that the questions below are addressed:
1. What index or indices should be used to replace Libor?
While there is currently no definite answer, there are three major groups trying to answer this question.
- From a banking perspective, the most important of these is the Alternative Reference Rates Committee (ARRC). This group has recommended initially that Libor be replaced with the single maturity Secured Overnight Financing Rate (SOFR) which, according to the NY Federal Reserve, is a broad measure of the cost of borrowing cash overnight collateralized by US Treasury securities. As the market develops, they have discussed the possibility of term structures in the future.
- Almost all participants in the derivative marketplace sign the International Swaps and Derivatives Association (ISDA) legal document. This grants ISDA, under certain circumstances, the right to make changes to the documentation without the participants’ approval. As such, ISDA can replace Libor in derivative transactions. They’ve issued several position papers, and while they are supportive of the SOFR index, the lack of a term structure is of concern, since many of the derivative transactions are based on a one- or three-month Libor index. ISDA has proposed that a compounded look back using daily SOFR over the floating frequency be used as the index in the future
- InterContinental Exchange (ICE) controls the current calculation of the Libor rates. In January 2019, ICE released a white paper on an alternative term to SOFR called the U.S. Dollar ICE Bank Yield Index. This index will be based on unsecured bank debt over various terms. If ICE receives positive feedback, it will begin publishing indices in early 2020.
Want to learn how SOFR is handled in PrecisionLender? Check out this article.
2. Assuming you move forward with SOFR, how do you handle the rate differences between SOFR and Libor and where do these differences stem from?
When looking at published SOFR rates from early April 2018 (first publication date) through the end of May 2019, one-month Libor and three-month Libor averaged about 12 and 36 basis points, respectively, above SOFR.
Some of the reasons for this are:
- SOFR is an overnight rate, while Libor indices are short-term (out to one year). Given the generally upward sloping yield curve at the short end of this market, there is likely to be a positive difference.
- SOFR is based on a secured near risk-free rate, while Libor is an unsecured rate.
- SOFR tends to be more volatile, especially at quarter and year end. Some of this quartered volatility has to do with bank capital charges based on call reports. The following graph shows a history of SOFR compared to one- and three-month Libor.
- We also see differences in SOFR vs. Libor because of the method used to determine the rates. SOFR is based on actual transactions that occur daily, ranging from a dollar volume of $850 billion to slightly over $1 trillion. Libor is what’s called an expert rate but has little actual volume. Randall Quarles of the Federal Reserve reported that in the second quarter of 2018 the median number of unsecured wholesale borrowing transactions used to make up the rate of one- and three-month USD Libor was five and seven per business day, respectively. Meaning, Libor is what the committee in London says it should be based on their expert knowledge, which might not always reflect reality.
- To handle the differences when SOFR replaces LIBOR on an existing loan, you must have a documented method to determine the additional spread at the time of transition. If a loan is currently priced at one-month Libor plus 2.50%, it is likely to generate the same Return on Equity only if the spread to SOFR is increased. The use of a good loan pricing system (that includes SOFR as an available index) can be very beneficial in determining these ROEs. ARRC has made some suggestions on how a bank can handle this difference at the time of termination of Libor.
3. When does the bank switch from Libor to SOFR and how do we transmit it to the customers?
This should be addressed in two ways: 1) How do we handle this going forward in new contracts? And 2) How do we handle this with already existing loans?
- On new transactions, the sooner your bank develops acceptable language to put in the loan documents, the safer you will be. ARRC has suggested some model language (see page 15 of linked document) and will continue to update this document over time.
- In terms of swap and derivative transactions tied to customer loans, ISDA, as noted, can make changes to existing contracts. Where possible, try to incorporate the ISDA definitions with the relevant loan contracts.
- For many existing contracts, the loan documents affecting floating rate Libor loans may have no language on the end of Libor. To remedy this, the last published Libor rate prior to termination of the index will be the fixed rate for the remaining term of the loan. If the yield curve is inverted and rates are high, this is clearly beneficial to the bank. Although it is likely that, as rates decline, the borrower may prepay the loan.
- In some cases, banks have included language that the termination of an index results in a transition to a new index based on WSJ or Bank Prime with the same spread as used with Libor. Since Prime is almost always above Libor (often by at least 250 basis points), this is postive income-wise for the bank, but may lead to reputational risk.
- Determine which existing longer term loans could be affected by a cessation of Libor. Then, mount an educational effort by relationship managers to encourage the bank’s borrowers to modify their existing documentation to include language similar to that decided in above.
4. How do we educate our customers about SOFR and is there some point prior to the termination of Libor that we stress SOFR type loans?
- There have already been several SOFR-based floating rate securities issued by federal agencies and corporate borrowers. A few banks have started to originate SOFR loans, although the volume was fairly minimal as of early 2019. Educating your customers, especially your commercial customers, is an important element in obtaining future acceptance. You can check the ARRC web site for potential material.
5. How do we handle our concerns over SOFR’s lack of reliable term structure?
- There are futures markets in SOFR and many hope that as this market matures it will provide a means to facilitate a term structure. Planning for the existence of a term structure is important, but until some more definite details emerge this can be difficult. Anyone concerned should sign up for the ARRC alerts. Assuming acceptance, the ICE index is meant to account for the term concerns. For some institutions, it might make sense to maintain the option to provide your borrowers with the alternative of SOFR and the U.S. Dollar ICE Bank Yield Index or the American Interbank Offered Rate (Ameribor).
6. How does an institution handle the disappearance of their Fund Transfer Rate (FTP) calculations based on Libor/Swap curve?
- Not being able to develop an accurate FTP curve can affect product and group profitability measures as well as employee’s potential bonuses. Having a satisfactory alternative for the short end of the FTP curve, which is currently determined by Libor, would be important and something that needs to be in the current planning process.
7. What is the effect of Libor termination on the bank's investment security portfolio?
- There is not much one can do as a purchaser to change any language in the security documents. But you do need to be aware of what it says. If you are not satisfied, you might think about selling the affected securities before the end of 2021, if not sooner.
Can the Libor Indices Continue After 2021?
There is nothing requiring the termination of the Libor index after 2021. Since the index is set by a committee of “experts,” as long as four global banks are willing to participate and ICE is willing to manage the process, the Libor and other Ibor indices can still be published. There is a view by some that the Libor index, given its importance, will be with us long past 2021.
However, even if Libor rates continue, its importance will likely be diminished in derivative, investment and lending operations. Making sure your bank is prepared for this new reality in the next decade is important to your continued profitability.
Also, “hoping” that Libor will be around after 2021 could be a fool’s bet. In early June 2019, Federal Reserve Vice Chairman Randal Quarles said: “Clarity on the exact timing and nature of the Libor stop is still to come, but the regulator of Libor has said that it is a matter of how Libor will end rather than if it will end, and it is hard to see how one could be clearer than that.”
The Time is Now
The time to act regarding the ending of Libor is now. To learn more, check out the recent PrecisionLender webinar on Preparing for SOFR: Changing the Playbook.
Interested in learning more about PrecisionLender? Request a demo of PrecisionLender.