The End of LIBOR

Globally, the London Interbank Offered Rate (LIBOR) is one of the most widely used interest rate benchmarks. However, the one-week and two-month LIBOR will no longer be published after December 31, 2021 and the one-day, one-month, six-month, and one-year LIBOR will no longer be published on June 30, 2023, necessitating a transition away from LIBOR. This article briefly discusses the reasons why LIBOR is expected to end and then concentrates on how financial institutions should prepare for this eventuality.

LIBOR is calculated as the average of interest rates that a panel of large London banks report that they would charge other banks to borrow unsecured for a specified period of time. Despite LIBOR’s widespread use as a reference rate by financial institutions, its reliability and sustainability have been called into question in recent years for a number of different reasons.

Concerned that LIBOR was becoming less stable and reliable, the Financial Conduct Authority (FCA), the United Kingdom’s financial regulator, announced in May 2017 that by the end of 2021, it would no longer compel banks to report their interest rates to the LIBOR administrator. The FCA also explained that although it would no longer require banks to submit their rates to the administrator, it would not prohibit banks from continuing to submit their LIBOR data after 2021. LIBOR’s administrator had previously stated that it will continue to calculate LIBOR as long as at least five banks continue to submit their information. This brought fears that LIBOR would continue to exist after the cessation of LIBOR but the rate would no longer be representative of the inter-bank interest rate offered and accepted by major financial institutions. There were also fears that this number would be more volatile. This occurrence has been referred to as the “zombie LIBOR.”

In an update on the timeline on the cessation of LIBOR, on March 5, 2021, the FCA and ICE Benchmark Administration announced that the one-week and two-month LIBOR will cease being published on December 31, 2021. The remaining tenors will cease to be published on a representative basis on June 30, 2023. With this, LIBOR’s administrator announced that a large number of its panel banks communicated that they would not be willing to continue contributing to the LIBOR tenors after these dates. Therefore, LIBOR’s administrator announced that as a result, it would stop publishing the relevant LIBOR rates on the announced dates unless the FCA exercised powers to require it to publish LIBOR on a synthetic basis. The FCA has stated that in circumstances where the synthetic rate may be compelled, it would not be representative of underlying markets.

In November 2020, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency (“OCC”), and the Federal Deposit Insurance Corporation (“FDIC”) issued a joint statement encouraging banks to stop using LIBOR as a reference rate in any new contracts as soon as practicable, and in any event by December 31, 2021. The statement emphasized that LIBOR’s continued use after this date would create safety and soundness risks that examiners would be instructed to examine accordingly. Further, the joint statement stressed that new contracts entered into before December 31, 2021 should either utilize a reference rate other than LIBOR or include robust fallback language identifying a replacement rate.

The FCA’s announcements have made the future of LIBOR uncertain but clarified the increasing risk associated with continued reliance on LIBOR. With these announcements, it is clear that financial institutions must prepare for the end of LIBOR.

Based on the potential problems with LIBOR in 2021, market participants and regulators have worked to identify the best alternative reference rate to replace LIBOR and implement plans to transition to that reference rate. The Federal Reserve convened the Alternative Reference Rates Committee (ARRC) to identify a more robust reference rate and to facilitate the transition way from LIBOR. The ARRC is composed of many private-sector entities that have a presence in markets that are impacted by LIBOR. Further, several federal regulators, including the FDIC, the Federal Reserve, the OCC, and the CFPB, serve as non-voting, ex officio members of the ARRC.

In 2017, the ARRC identified the Secured Overnight Financing Rate (SOFR) as its recommended best alternative to LIBOR. SOFR is based on transactions in the U.S. Treasury repurchase market, measuring the cost of borrowing cash overnight collateralized U.S. Treasury securities in the market. Because of the size and liquidity of the market underlying SOFR, the ARRC believes that the index is more robust and resilient than LIBOR. To support the transition to SOFR, the ARRC has begun implementing steps to help SOFR gain momentum. As a part of this work, in April 2018, the New York Federal Reserve Board began publishing SOFR in conjunction with the Office of Financial Research.

Following the selection of SOFR as its alternative reference rate, the ARRC also published a Paced Transition Plan that outlines specific steps and timelines to promote the adoption of SOFR. These steps focus on updating existing contracts that cite LIBOR as the reference rate and encouraging the issuance of new products that use SOFR. The ARRC has supported the issuance of SOFR-linked products and securities. Recognizing the importance of updating existing contracts that use LIBOR as a reference rate, the ARRC has developed guiding principles for fallback contract language. Following this, the ARRC released recommended fallback contract language for several products including adjustable-rate mortgages and floating-rate notes.

On November 15, 2019, Fannie Mae and Freddie Mac announced their support of the ARRC’s fallback language and their plan to incorporate the recommended language into its uniform notes and other legal documents for ARMs. They also announced their plan to offer new SOFR-based index and ARM products and have now become regular issuers of SOFR-indexed debt. Similarly, on February 5, 2020, Fannie Mae and Freddie Mac announced that they had incorporated the ARRC’s fallback language into their existing standard ARM notes and riders. Further, they announced that, by the end of 2020, they will no longer acquire loans indexed to LIBOR.

In November 2020, the Federal Reserve System, OCC, and FDIC released a joint statement explaining that they would not be endorsing a specific replacement rate for LIBOR loans because institutions should select a reference rate that they determine is appropriate based on their funding model and customer needs.

Given either the upcoming end or instability of LIBOR, financial institutions should prepare for 2022 and June 2023. Institutions should ensure they have comprehensively assessed their risks and develop an action plan to mitigate those risks. It might be best to appoint one person to head the financial institution’s strategy and implementation. First, financial institutions should review their existing agreements that use LIBOR as a reference rate. The existing agreements should be divided into those in which a third party is involved, i.e., trust preferred securities or swap agreements, and those in which the financial institution and the other contracting party are the only parties to the transaction (the In-House Contracts).

Any financial institutions that have issued debt securities (such as subordinated debt or trust preferred securities) at the holding company or bank level should check the documentation governing those issuances. Typically, those contracts provide for the substitution of a comparable rate. Financial institutions should confirm the substitution language and also review the procedures for substituting the rate. If the issuance involves an institutional trustee, such as Wilmington Trust Company for many outstanding trust preferred securities, it may be necessary or advisable to contact the institutional trustee far in advance of the LIBOR end to discuss the process of changing rates.

The In-House Contracts should be further subdivided by the LIBOR rate that is used (one-week, two-month, 12-month, etc.). In-House Contracts using one-week and two-month LIBOR as a reference rate should be subdivided into those whose term ends prior to the end of 2021 and those whose maturity is after 2021. In-House Contracts using the other LIBOR tenors should be subdivided into those whose term ends prior to the end of 2023 and those whose maturity is after 2023.

Next, financial institutions should ensure that existing In-House Contracts are able to substitute a comparable rate. Then, the financial institution should determine whether it will substitute a new rate and a new margin and at what point the change will be made. Consideration should be given to the stability of a new rate and a new margin. The decision on a new rate and a new margin may involve several committees and personnel at the financial institution as different considerations of interest rate risk, stability, competition and other factors will influence the ultimate substitute reference rate the financial institution will utilize. In assessing a rate, financial institutions should consider their funding costs and their customers’ needs. With respect to variable rate consumer loans, financial institutions should consider their notice requirements under the contract and disclosure requirements under Regulation Z. For variable rate consumer loans, financial institutions should ensure that they select a rate that is considered comparable to LIBOR. Financial institutions should note that the Prime Rate will continue to be available unaffected by the impending demise of LIBOR.

After a decision has been made on the financial institution’s new reference rate, it may be advisable to educate the financial institution’s LIBOR customers on the new rate, especially if it is a rate that customers may not be familiar with. Although a customer may not have the right to contest the new reference rate, educating the customer may alleviate the customer’s anxiety about the new reference rate.

Finally, the financial institution should determine how the new reference rate will be implemented. The financial institution should consider whether it will draft amendments to existing loan documents to implement the new reference rate or whether it will simply notify the other party to the contract of the new reference rate. Financial institutions should contact their legal counsel for advice on this issue.

The WBA forms distributed through FIPCO currently contain a provision that if the index rate a lender uses with respect to a particular loan becomes unavailable then the lender may substitute a comparable index rate. To alleviate concerns with the zombie LIBOR, FIPCO has created the LIBOR Addendum. This Addendum allows the lender to replace LIBOR if a “Replacement Event” occurs. The Addendum is drafted to define a Replacement Event to include a situation in which LIBOR would continue to exist in a zombie state. The LIBOR Addendum can be used for new loans that use LIBOR as the index rate. The form could also be used for existing loans, but the borrower is required to sign the LIBOR Addendum.

Financial institutions should stop using LIBOR as a reference rate in new contracts as soon as practicable, and, in any event by December 31, 2021. When making new loans that use LIBOR as a reference rate, financial institutions should ensure that any new contracts include robust fallback language that will allow for an easy transition to a new reference rate. Consideration should be given to using the LIBOR Addendum to In-House Contracts. Additionally, financial institutions should consider incorporating the fallback language adopted by Fannie Mae and Freddie Mac to any residential real estate mortgages using LIBOR intended to be sold on the secondary market.

Taking the steps outlined above will help financial institutions mitigate their risks in the post-LIBOR market.