Since becoming a foundational reference rate in the mid-1980s, the London Interbank Offered Rate (LIBOR) has seen a sharp decline in industry confidence since the Great Recession—in part because of dwindling transaction volumes and partly due to fallout from the 2012 manipulation scandal. As a result, On July 27, 2017, U.K.'s top regulator, the Financial Conduct Authority, announced the LIBOR interest rate benchmark will be phased out by the end of 2021. Any bank with products tied to LIBOR should develop a strategy now to handle the transition from LIBOR to an alternative reference rate.
Despite the well-forecasted sunset date, as of mid-2018 LIBOR still formed the basis for an estimated $400 trillion of contracts, about one-half of which are in U.S. dollars. In the U.S., alternative rates have been slow to gain traction. In addition to serving as a reference rate for many bond investments, LIBOR still serves as a benchmark for many consumer loans including variable-rate mortgages, pledged-asset lines, and margin loans. The financial industry at large will need to accelerate its transition pace in order to fully convert prior to Dec. 31, 2021.
The predominant LIBOR alternative in the United States is the Secured Overnight Financing Rate (SOFR), developed by the Federal Reserve and the Federal Reserve Bank of New York's Alternative Reference Rates Committee (ARRC). SOFR is based on repo interest rates; repos are a key source of short-term funding, so basing the reference rate on these transactions makes sense for the U.S. financial system. However, many significant questions remain for SOFR. For example, SOFR currently lacks a term rate (though ARRC anticipates its creation by the end of 2021).
Another option is the U.S. Dollar ICE Bank Yield Index, proposed by the Intercontinental Exchange Benchmark Administration (IBA). IBA published the ICE index and requested industry comment in January 2019. The index measures the yields at which investors are willing to lend U.S. dollar funds to large, internationally active banks on a wholesale, unsecured basis over periods of one, three, and six months. However, the ICE index is still in development, with the most recent update from IBA—released in October 2019—outlining a preliminary index methodology. The update also provided revised testing results from December 2017 – September 2019. IBA has indicated it intends to continue testing and finalizing the index methodology with a targeted production launch later this year.
If LIBOR becomes unavailable, WBA forms distributed through FIPCO provide the lender with means to substitute a comparable rate. The possibility exists that LIBOR declines, but continues to be calculated. WBA is working closely with BoardmanClark law firm to prepare for this circumstance. In addition, the ARRC has developed fallback language institutions may include in their contracts.
Transition Checklist for Banks:
Wisconsin banks should weigh several different factors during the transition away from LIBOR. First (as always) is regulatory compliance. In a June 3, 2019 speech at an ARRC Roundtable, Federal Reserve Vice Chair for Supervision Randal K. Quarles urged attendees to take warnings about LIBOR's stability seriously and "the transition should begin happening in earnest. … Regardless of how you choose to transition, beginning that transition now would be consistent with prudent risk management and the duty that you owe to your shareholders and clients." Other regulators have followed suit, with the FDIC's Supervisory Insights released on March 20, 2019 focusing on LIBOR.
A second factor to consider is impact on customers. Most bank customers impacted by this transition don't have a strong understanding of what LIBOR is and what the change means for them. Bank staff will need to develop clear messaging to explain and reassure clients. Transparency on any contract amendments will also be vital.
Finally, bank leadership must factor in cost to their transition plans. Switching to an alternative reference rate—whichever one the bank chooses—is a costly endeavor. The bank should budget for expenses including writing new contracts, developing new risk management and investment strategies (and potentially implementing new software to facilitate those strategies), training bank personnel, and communications materials to inform and/or educate customers, shareholders, and regulators.
Note: The above information is not intended to provide legal advice; rather, it is intended to provide general information about banking issues. Consult your institution's attorney for special legal advice or assistance.
Want to really get in the weeds on LIBOR and its alternatives? Dive in!
- Federal Reserve Bank of New York — A User's Gide to SOFR
- Financial Conduct Authority (U.K. regulator) — LIBOR: Preparing for the End
- Securities Industry and Financial Markets Association (SIFMA) — SOFR Primer
- Intercontinental Exchange Benchmark Administration (IBA) — The ICE Bank Yield Index
- Bank for International Settlements (BIS) — Beyond LIBOR: A Primer on the New Reference Rates
- Money and Banking — Replacing LIBOR
- Charles Schwab — LIBOR Countdown: Navigating the Transition