Prepare for the Transition from LIBOR

By the end of 2021, the London Interbank Offered Rate (LIBOR) will be phased out and replaced with a new interest rate reference for new and existing loans. Global financial services have used LIBOR since the 1980s as a reference rate to price mainly variable rate loans and securities, deposits and interest rate hedging transactions, as well as derivatives, discount products, debt securities/commercial paper and even default interest rates. 

LIBOR is published daily and is calculated from hypothetical borrowing transactions submitted by a few banks, making it subject to manipulation. In fact, in a 2008 scandal, one banker manipulated LIBOR lower, the opposite of what would be expected during a credit squeeze. The Alternative Reference Rates Committee (ARRC), convened by the Federal Reserve Board, officially endorsed the Secured Overnight Financing Rate (SOFR) in 2017 as the preferred benchmark to replace LIBOR.

SOFR's price is based on actual market borrowing rates for overnight U.S. Treasury repurchase agreements, or repos. It’s not a perfect solution though, because the repo market is influenced by a concentration of large banks that act as intermediaries between the Federal Reserve and smaller financial institutions. If these large banks hold on to cash to meet their own needs, it could limit liquidity to smaller banks, and cause SOFR rate volatility and interest rates to increase. This occurred in mid-September 2019 and SOFR rose to 5.25%, from its stable rate of slightly over 2%. Still, SOFR is thought to be more stable that LOBOR for determining predictable rates.

The FFIEC notes that institutions can face a variety of risks due to on- and off-balance sheet assets and contracts that reference LIBOR, including:

  • Operational difficulty in quantifying LIBOR exposure
  • Financial, valuation, model and “safety and soundness”
  • Inadequate risk management processes and controls to support the transition
  • Consumer protection-related risks
  • Limited ability of third-party service providers to support operational changes
  • Potential litigation and reputational risk 

What can be done to mitigate these risks? Institutions should:

  • Identify and quantify LIBOR exposures
  • Consider limiting exposure by discontinuing origination or purchase of LIBOR-indexed instruments
  • Identify and address contracts with inadequate fallback language. New contracts for loan products with maturities beyond 2021 should utilize a reference rate other than LIBOR or have robust fallback language that includes a clearly defined alternative reference rate after LIBOR’s discontinuation.
  • Understand the legal, operational, and other risks associated with consumer financial products such as adjustable-rate mortgages, HELOCs, student loans, automobile loans and credit cards
  • Evaluate reliance on third-party service providers that provide valuation/pricing, modeling, transaction processing, document preparation and accounting services and determine if they will be able to accommodate alternative reference rates after LIBOR’s discontinuation. 
  • Supervisory staff will ask institutions about their planning for the LIBOR transition including the identification of exposures, efforts to include fallback language or use alternative reference rates in new contracts, operational preparedness and consumer protection considerations.

Read the FFIEC statement on managing the LIBOR transition. 

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