Greg Corombos, News Director at Radio America 00:00
Hi, I’m Greg Corombos. Welcome to Banking Compliance Insights, a podcast series from Wolters Kluwer. This series was created to deliver insights on compliance trends and strategies for navigating today’s regulatory and risk environments. Today’s episode, “And SOFR Something Completely Different,” will focus on the end of the London Interbank Offered Rate, or LIBOR, and the industry switch to SOFR, the Secured Overnight Financing Rate. Here to lead our discussion on this subject is Wolters Kluwer Vice President of Banking Compliance Solutions, Samir Agarwal. He is joined by Andy Dunn, Manager of Specialized Consulting with Wolters Kluwer. Samir, let me pass the conversation over to you.
Samir Agarwal, Vice President, Banking Compliance Solutions, Wolters Kluwer 00:46
Thanks, Greg. LIBOR, SOFR, and then also the Governing Committee, the Alternative Reference Rates Committee, better known as ARRC, seem to guide us with how we do lending in the United States. Rates in the U.S. rely on this backbone and these indices to drive all types of lending, whether it’s interbank, consumer loans, commercial or even mortgage rates. Today, Andy Dunn is going to join us. We’ve invited him over to tell us a little bit about his expertise in the area and what to expect. Andy, welcome. Tell us a little bit more about your role at Wolters Kluwer and the clients that you serve.
Andy Dunn, Manager of Specialized Consulting with Wolters Kluwer 01:27
My role here at Wolters Kluwer is as a manager within our Regulatory Compliance Analysis team. We monitor and maintain our content and solutions for the financial services industry at a federal level and state level in all 50 states and D.C. As a result, anytime there’s a question or a topic that relates to interest rates, our ears perk up, we lean in, and we listen. One of the things that has caught our interest over the past couple years is movement away from LIBOR, which brings us to the topic of our podcast today. I’m sure one of the questions you may have is, what is LIBOR?
Samir Agarwal, Vice President, Banking Compliance Solutions, Wolters Kluwer 02:17
Absolutely. What is it? How is it used, just so we can understand it better?
Andy Dunn, Manager of Specialized Consulting with Wolters Kluwer 02:23
LIBOR is a wonderful little acronym known as the London Interbank Offered Rate. An interesting little nugget about it’s calculated every applicable London business day for five different currencies, using seven different tenors or time periods for each currency. As a result, there are 35 individual rates that get published every day for LIBOR. You may have seen this in financial websites or periodicals that reference USD LIBOR — and then it could be the one week, one month, two months, sometimes three months, six months, or 12 months. All of these different rates get published, and there are four other currencies where it gets published, but primarily throughout the globe, the U.S. dollar LIBOR rate is the predominant rate that’s used.
Samir Agarwal, Vice President, Banking Compliance Solutions, Wolters Kluwer 03:28
It sounds pretty thorough, where it’s all-encompassing of what the world’s major currencies are. And over a timeframe that it seems repeatable and really represents the international financial landscape. Is that right?
Andy Dunn, Manager of Specialized Consulting with Wolters Kluwer 03:44
Yes, it’s frequently relied on across the globe. Financial institutions of all sizes rely on these large banks to lead the way. Almost like the North Star, where we follow and how we line things up. Think of it as they’re leading the pack, and we’re all following on the same path to stay on the straight and narrow.
Samir Agarwal, Vice President, Banking Compliance Solutions, Wolters Kluwer 04:07
Can you give me an example of just a really positive transaction that relies on LIBOR?
Andy Dunn, Manager of Specialized Consulting with Wolters Kluwer 04:13
Sure, there is a degree of certainty when you put together a package of loans, that everything tied to this rate, it’s widely accepted. Everyone knows what that rate is. You don’t have to worry about, anywhere in the globe, someone looking at a rate that’s identified in a financial contract and saying, “Hmm, well, I wouldn’t possibly know where to go find that information to verify what that rate is.” It’s so widely accepted and published that everyone knows what it is. It brings that uniformity of awareness and availability across the globe.
Samir Agarwal, Vice President, Banking Compliance Solutions, Wolters Kluwer 04:59
Let’s starts off talking about why are we switching off of it? What’s going on that says, “Hey, this is not reliable anymore?”
Andy Dunn, Manager of Specialized Consulting with Wolters Kluwer 05:05
That’s really the interesting thing—one of the outcomes of the 2008 financial crisis, commonly referred to in the United States as the Great Recession, was the determination that LIBOR is too susceptible to manipulation by these large banks, particularly if they misuse their influence over LIBOR, to project better creditworthiness and/or improve their trading position. It’s not necessarily that, “Oh my God, there’s this vast conspiracy going on.” Nevertheless, if you had participants not doing what they should have been doing, there is the increased risk that it could be manipulated. And there are various perceptions about the causes of that financial crisis. What came out of that was a realization that there’s probably a better way for us to manage our risk. Various groups across the globe got together and started thinking about what we could do better going forward.
Samir Agarwal, Vice President, Banking Compliance Solutions, Wolters Kluwer 06:17
Was there a consensus?
Andy Dunn, Manager of Specialized Consulting with Wolters Kluwer 06:18
That consensus has really evolved. In the United States, that consensus has been led by a group known as ARRC or the Alternative Reference Rates Committee.
Samir Agarwal, Vice President, Banking Compliance Solutions, Wolters Kluwer 06:31
That is only U.S.-based, right?
Andy Dunn, Manager of Specialized Consulting with Wolters Kluwer 06:33
That is correct. ARRC meets and collaborates with its counterparts across the globe. But ARRC is strictly a U.S.-based committee.
Samir Agarwal, Vice President, Banking Compliance Solutions, Wolters Kluwer 06:44
What are they suggesting for transactions and banks today? I guess it’s going to mainly affect U.S. banks. What’s the suggestion that the committee is giving to the United States banks?
Andy Dunn, Manager of Specialized Consulting with Wolters Kluwer 06:56
What they’ve done is, after studying and considering a number of different options, they landed on a new index. They’ve named it SOFR, or the Secured Overnight Financing Rate, that’s published by the New York Federal Reserve. And the reason why they’ve opted for that is, if you remember earlier in the game, what is LIBOR? It was based on an average of what a limited number of banks think their own funding costs are. ARRC switched that up to take a different approach, and based it on a broader set of financial institutions or banks, on actual transactions. And so, the risk that one or more financial institutions would manipulate LIBOR because it was a smaller set – you don’t have that risk anymore because it’s based on such a broad average. The concept of “a rising tide lifts all boats” comes into play with SOFR. For that reason, ARRC has recommended SOFR as the replacement rate.
Samir Agarwal, Vice President, Banking Compliance Solutions, Wolters Kluwer 08:11
There’s this idea that we were once connected throughout the entire globe, and now we’re not. What impact does that have given that this is a U.S.-based rate? How does that really affect global transactions that take place?
Andy Dunn, Manager of Specialized Consulting with Wolters Kluwer 08:27
That’s one of the evolving areas right now. There is no mandate to use a particular alternative rate. It’s an evolving area of practice. ARRC is certainly recommending to transition over (to SOFR) because they think that is the best path forward. What we’re going to see as the market adapts and adopts is that it may be SOFR that continues to take root and grow globally, or it may be another rate. But in the meantime, there is the decision that’s been made. LIBOR will no longer be regulated, or as reliable, is probably a better way to describe it, because those large banks are no longer participating in it. To provide a better common sense analogy, if we based an understanding of what the weather was like by a handful of us going outside and saying, “It’s a clear, sunny day here.” And Samir, you went outside and said, “Well, it’s overcast,” and someone else went outside and said, “Oh, well, it’s raining here.” Maybe we could come up with an average and say, “On the whole, it looks like a fairly decent day, with nice warm weather.” But the more people we take out of that equation, the less accurate of a picture we’re going to have. That’s really the risk associated with LIBOR because these large banks are all pulling out of contributing to LIBOR going forward. If you’ve only got one or two financial institutions or large banks contributing to what LIBOR is, and the body that publishes, it isn’t confident in it. That risk is going to permeate the global markets, which is why switching to something where you’ve got broader participation, and it’s based on actual transactions, the thought is that it’s a better way forward.
Samir Agarwal, Vice President, Banking Compliance Solutions, Wolters Kluwer 10:32
It’s almost as if before we were basing it on confidence, and now we’re basing it on true transactions. But it’s based on reacting to a trend, which also needs some checks and balances ultimately. With that recommendation, if we take a look at how to transition to LIBOR, what are the things that we need to know about? Is the date hard and fast?
Andy Dunn, Manager of Specialized Consulting with Wolters Kluwer 10:53
The date is hard and fast. The group that’s responsible for publishing LIBOR is ICE, the Intercontinental Exchange based out of the New York Stock Exchange. They’ve confirmed, despite the pandemic and everything else, because that’s been a question. This has been in motion for several years now. LIBOR will become less reliable on December 31, 2021. And a number of these large financial institutions have begun making their switch over to SOFR already. We’re seeing that trend occur in other groups of financial institutions that don’t consider LIBOR. For example, in the mortgage market in the United States, the various federal agencies and the Government-Sponsored Enterprises (GSE), as of September 2020, they are no longer purchasing loans tied to the LIBOR index. Everything has to be tied to either the one-year Treasury index or the SOFR index. There’s movement, where even the one-year Treasury index, those Uniform Instruments relied on by the Government-Sponsored Enterprises, they’re going to be retired as well. If you’re looking for an Adjustable Rate Mortgage loan, it’s all SOFR, all day, every day. If it’s not tied to SOFR, there won’t be a secondary market for that.
Samir Agarwal, Vice President, Banking Compliance Solutions, Wolters Kluwer 12:24
How do we deal with the past, like the historical transactions? Will they still be honored? Or is it what’s done is done, and everything new is new and forward?
Andy Dunn, Manager of Specialized Consulting with Wolters Kluwer 12:32
They will still be honored. However, ARRC has published a toolkit, checklists and readiness tools to help with that. It is to make sure that between now and when LIBOR becomes unreliable, there’s improved fallback language that provides a better mechanism in those financial contracts. When the rate you selected as LIBOR becomes unreliable, there’s a clear path as to what the substitute index will be. Additionally, loans or any kind of financial transaction that may still be in flight that was created many years ago and is tied to the LIBOR index. There are ways where you can modify that fallback language to bring it in line and to facilitate a better path forward. The key here is preparation and moving forward with the transition. The various federal regulatory agencies, as recently as November 6, put out interagency guidance to all their different financial institutions as joint guidance to encourage. Now is the time as we move into 2021 to really start looking at where you’re at as far as the transition. It’ll be helpful, so you’re better able to manage your risk at the end of 2021.
Samir Agarwal, Vice President, Banking Compliance Solutions, Wolters Kluwer 14:10
Tell me a little bit about some of the practical steps as a lender that we would need to take. I know you mentioned to start doing some self-evaluation with some checklists. What is provided by the different agencies? Should we engage vendors for an extra health check? How does someone prepare for the switch and make sure that they’re going to be able to still do mortgage loans and that they can sell to the GSE or any other type of lending?
Andy Dunn, Manager of Specialized Consulting with Wolters Kluwer 14:38
One of the things is definitely checking with your vendors. For example, we at Wolters Kluwer have already updated all of our content and our software solutions to support the ability to select the SOFR index. We also have the ability to select other indexes. The key thing there is SOFR is not required, but certainly recommended by ARRC and for the mortgage market on the secondary market per se. That’s where SOFR is clearly being given a preferred seat at the table. On the other hand, if you’re willing to portfolio a loan, you don’t have to tie that loan to SOFR. Coming back to it, your technology solutions or content that you use to write those financial contracts needs to have that enhanced fallback language. If it’s referencing SOFR, you have to confirm it’s available to you or alternative indexes are available to you. It’s your policies and procedures. It’ll come up during your exams, either now or in the future. Your prudential regulators will inevitably be asking, “Hey, how are things going? Are you still tied to LIBOR? What are your plans? How do you plan on approaching it?” One path is to follow the rest of the herd and go with SOFR. The other option is to chart your own path, and that’s fine. In order to do that, you certainly need to do your homework and have conversations as an operating community for your governance structure as well as operationally with your individual employees to structure things and to be able to have your reporting in place. As we head into 2021, now is a really opportune time to start that.
Samir Agarwal, Vice President, Banking Compliance Solutions, Wolters Kluwer 16:41
What is the right time to start paying attention to this? Is it now since we’ve already had one change take place, or is it because it’ll be less supported and less reliable? Do we have a lot of time for the change?
Andy Dunn, Manager of Specialized Consulting with Wolters Kluwer 16:56
The conventional wisdom, and what’s being advocated by ARRC, and all the prudential regulators is start working on it. Now, the best way to describe that in layman’s terms is if you’re given a week to run a marathon, you can certainly choose to wait to do that on the last day of the week, or you could do a couple miles every day. It becomes a little easier to complete and reach your goal. That’s certainly the theme that we’re seeing from ARRC as well as all the prudential regulators, encouraging financial institutions to take stock of where they are today. Make plans and be able to make that transition and put their plans in place over a more gradual period of time, as opposed to waiting toward the fourth quarter of 2021 and trying to do it all in one fell swoop.
Samir Agarwal, Vice President, Banking Compliance Solutions, Wolters Kluwer 17:51
You mentioned before that Wolters Kluwer also has some expertise that can help individuals out or entire firms out. How are you positioned, and how is the company positioned to assist in the shift to SOFR?
Andy Dunn, Manager of Specialized Consulting with Wolters Kluwer 18:04
Beyond our content and our software product solutions, we have our service organization that can help with implementing and doing these assessments, looking at checklists, and helping an organization go from where they are today to where they’re complete and ready to go. It’s really a matter of, “Do I need assistance?” or “Do you have it all covered?” If you do, here at Wolters Kluwer, and I’m sure there are other groups available as well, they’re standing by and ready to help you. Just let us know how we can help you move forward, and we’ll be glad to engage with you.
Samir Agarwal, Vice President, Banking Compliance Solutions, Wolters Kluwer 18:44
Thanks for the very informative information, Andy. I’m sure it’s going to be very useful for those that have just tuned in to our podcast and also giving us the insight into other services and capabilities that we need to be looking for. If ARRC’s making recommendations and there are many different checklists or health sanity advisements, then as a lender, I’d actually be trying to take a look at what we have before trying to just make a decision on what’s next. I appreciate you coming in and really informing us. I’d love to take the conversation to the next level when the time is appropriate. Thank you for coming and joining us.
Andy Dunn, Manager of Specialized Consulting with Wolters Kluwer 19:20
You’re welcome. My pleasure.
Greg Corombos, News Director at Radio America 19:22
That’s Wolters Kluwer Vice President of Banking Compliance Solutions, Samir Agarwal, joined on this episode by Andy Dunn, Manager of Specialized Consulting with Wolters Kluwer. Wolters Kluwer hosts this podcast and is a market-leading provider of advisory services and technology solutions for optimizing compliance and risk management programs. For more information and additional guidance, please visit WoltersKluwer.com or call 1-800-397-2341. Please join us for future podcasts focused on navigating emerging trends in regulatory compliance.