While most community banks do not use LIBOR extensively for their loans and deposits, many community banks have at least a handful of loans or other cash instruments that do reference LIBOR as the benchmark rate. This article outlines what community banks need to know at this stage of the LIBOR transition period.
Transition From LIBOR
In November 2014, the Federal Reserve convened the Alternative Reference Rates Committee (ARRC). ARRC had two goals: first, to identify alternative reference interest rate that is more firmly based on market transactions; and second, to identify an adoption plan to facilitate the transition from LIBOR. ARRC has identified SOFR (Secured Overnight Financing Rate) as the alternative reference interest rate. This blog will focus largely on the second ARRC goal – the adoption plan to transition from LIBOR to SOFR.
On June 22, 2017, ARRC selected SOFR as the preferred reference rate for U.S. dollar contracts. SOFR is a Treasuries repo financing rate and is published by Federal Reserve Bank of New York. SOFR is a risk-free overnight rate, and the historical relationship between SOFR, Fed Funds effective rate and 1-month LIBOR is shown in the graph below. While the history on SOFR is short (starting in April 2018), the relationship between SOFR, LIBOR and Fed Funds is very close. SOFR typically trades close to LIBOR but with higher volatility due to its methodology and the wide dispersion in repo data.
For most community banks, even those that have hundreds of millions of dollars of LIBOR based products, the transition from LIBOR to SOFR will have minimal economic impact arising strictly from the change in the level of interest rates. However, if not properly addressed, the impact could be significant from customer relationship, operational, contractual, and regulatory and supervisory perspective.
Will LIBOR Remain Past 2021?
The ICE Benchmark Administration in Atlanta Georgia (IBA) administers LIBOR and provides updates on the status of LIBOR in light of the transition to SOFR. IBA continues to publish indications that panel banks will remain who will be interested in setting LIBOR past 2021. The IBA is currently in discussions with member banks that may continue to submit LIBOR bids post 2021 and up to 2025 at a minimum. Various money-centered banks have indicated that they may be interested in continuing to set certain LIBOR contracts (most likely 1 and 3-month terms).
But despite the possibility that LIBOR remains a viable reference rate post-2021, large US banks are actively engaged in developing strategies, and contingency plans for LIBOR transition and regional and community banks are taking up this issue next.
Practical Considerations For Community Banks
LIBOR is referenced by an estimated US $350 trillion of outstanding contracts in maturities ranging from overnight to more than 30 years. The important question for community banks is whether during the transition period, will banks be permitted to retain LIBOR as a reference rate, be required to amend contracts to reference SOFR without economic impact (market, legal and documentation costs), or be allowed to amend the definition of LIBOR through a specific grandfathering protocol. The answer to these questions is still not clear, and however the post-2021 transition unfolds, community banks can and should know any LIBOR exposure that matures after 2021 plus add language today to instruments that are LIBOR based to more easily transition to SOFR, if and when that may be required in the future.
Community banks should consider three broad variables in LIBOR transition strategies:
Triggers – when would a community bank want to transition from LIBOR to SOFR. This may occur upon permanent cessation of LIBOR or before such an event.
Amendment or hardwired approach – community banks would develop language in the documentation that would permit fallback to SOFR. In the amendment approach, banks would have the language to provide a mechanism for streamlined amendment of the contract. In the hardwired approach, banks would provide customers with upfront clarity on how a replacement rate will be identified and implemented.
Replacement of benchmark spread – because SOFR is a risk-free rate, and LIBOR is a risk-based rate, a spread adjustment is required. This adjustment will most likely be recommended by a relevant governmental body (such as ARRC). Such language has yet to be published, but it is generally believed that this adjustment will be based on historical mean or median relationship between the two rates (which appears to be approximately 20 to 25bps depending on LIBOR term).
Addressing LIBOR fallback in new contracts
ARRC has not yet endorsed language for use in LIBOR-based contracts. In the interim, we have seen many banks use the following two alternatives in their cash contracts (loans and deposits):
Option A: If the Index becomes unavailable during the applicable term of the contract, banks may designate a substitute index after notifying the customer.
Option B: In the event that the Index is no longer published or is abolished or becomes unascertainable, during the term thereof, bank, if applicable, shall designate a comparable reference rate which shall be deemed to be the Index hereunder.
Addressing LIBOR fallback in legacy contracts
ARRC and International Swaps and Derivatives Association, Inc. (“ISDA”) has been conducting market-wide consultation groups for fallbacks for various contracts; neither body has yet endorsed a protocol to facilitate amendment of legacy contracts. However, such language is expected to be formally endorsed at some point in 2019.
While the transition from LIBOR to SOFR is not yet completely set in stone for every contract. Community banks should include the appropriate language and transition triggers into their loans, deposits and derivative contracts. Right now, big banks, regional, and community banks are still using LIBOR with various fallback provisions. Community banks should expect their regulators to ask if the bank has assessed its exposure to LIBOR transition and if the bank has developed a plan for such a transition.
Submitted by Chris Nichols on January 23, 2019