ComplianceApril 16, 2019

A Risk Manager’s Guide to the Reference Rate Transition

(As published in ABA Banking Journal, April 2019)

With Libor’s future uncertain, here are some steps for assessing risk, amending contracts and selecting new rates.

Although it is in widespread use today for hundreds of trillions of dollars’ worth of financial instruments worldwide, the London Interbank Offered Rate (Libor) faces a future in which it will either no longer be published or will become a poor benchmark to base rates. The U.K. Financial Conduct Authority has received support from participating banks for continued submission of the rates through the end of 2021. This gives the industry time to prepare for a move away from the Libor to a new index. But there is some concern that the small number of transactions and litigation risks to the panel banks in submitting the rates could cause the panel banks to stop submitting sooner.

Beyond 2021, what will happen to the Libor and when is uncertain. Will it continue to be published? Will there be some sort of official announcement by UK or U.S. officials indicating that it is no longer available for use as an index to base rates? While the future of Libor is uncertain, the financial industry is preparing for a shift away from it.

The Federal Reserve convened the Alternative Reference Rates Committee—a group of public-sector and market participants—to work on an orderly transition away from U.S. dollar Libor, including development of an alternate reference rate and recommending contract fallback language which provides the protocol in moving to a new index. The ARRC selected an alternative recommended index: the Secured Overnight Financing Rate, or SOFR.

Unlike Libor, SOFR reflects a secured rate. Therefore, it is expected to be lower than the unsecured Libor. Today, only a daily SOFR is available. However, futures trading of the daily SOFR has begun and over time it is expected that this will allow for benchmarks for the creation of additional SOFR terms like Libor has. (There are seven Libor term rates today: overnight, one week, one year and one, two, three, and six months.)

The ARRC is working to publish recommended fallback language for each contract type. Each recommendation will provide for a trigger event for moving from the current index to a new index, a provision on how a new index and margin will be determined, and for the allowance of contract amendments if applicable. This will allow the industry to get fallback language in new contracts which prescribes how a new rate, margin and amendment if applicable will be determined should another Libor-like index concern occur.

The focus has been on fallback language to be used in contracts going forward. Currently, the ARRC does not appear to be giving guidance on what to do with legacy contracts. However, a footnote in the September 24, 2018, ARRC consultation provides the following: Both cash product and derivatives market participants may wish to transition transactions prior to the cessation of Libor and may do so by amending contracts rather than relying on fallback provisions. These contracts currently have somewhat vague language requiring that the Libor no longer be “published,” “cease to exist,” or be “available” before the index can be changed. This is because the industry collectively did not anticipate today's Libor circumstance and, in some cases, because of regulatory limitations.

Documentation gathering and review

Financial institutions are gathering information on current and legacy documents to determine where Libor language exists and what the fallback language allows. In gathering this documentation, there are a couple things to remember. In addition to current loan documents, loan documents associated with loan products no longer offered, but with outstanding loans, will need to be reviewed. It is also important to review the documentation to determine if there have been any changes to the Libor language over time.

Document review is needed to determine what documents will need to be changed to accommodate the move away from Libor and adoption of new fallback language.

For legacy contracts with outstanding loan balances, the fallback language needs to be reviewed to understand what can be changed on legacy loans (index and margin or just the index) and the circumstances when the change can occur. In some cases, contracts may not have any fallback language.

Deciding whether to amend legacy contracts

Given the uncertain future of Libor and the various types of contract language surrounding when a change to the index can be made, financial institutions are weighing whether they need to amend legacy contracts. There are advantages and disadvantages to weigh in deciding on whether to seek amendment. Disadvantages include the time it takes to amend, the costs and the risk that not all borrowers might agree to amend contacts.

However, amending contracts can offer several advantages as well. These include potentially lower litigation risk through borrower agreement versus a unilateral change by the financial institution. There is no certainty in how a new index will move relative to the Libor, and if both exist at the same time, litigation might be likely if the new index plus a margin results in a higher rate. Amending also offers an opportunity to educate engaged borrowers on the need for the change and the borrower fairness considerations taken, potentially further reducing litigation risk. Amending now also helps avoid potential additional risks should the panel banks stop reporting prior to then and minimizes uncertainties around relying on the current vague fallback language to trigger the ability to move to a new index.

Whether a financial institution seeks to amend contracts or not, it is important to consider potential efforts to reduce litigation, regulatory and reputational risks. In addition to educational communications to borrowers, this might include creative interim solutions for changes to the index and possibly the margin on legacy contracts through the end of 2021.

Choosing a new index for both future and legacy contracts

The ARRC has set the stage for use of SOFR to base rates on for contracts to be executed in the future and is working to get industry consensus on the appropriate fallback language by contract type. Given how well the ARRC recommendations will have been vetted by the time the final recommendations are made, it seems rational that the industry will mainly follow the ARRC's recommendations.

It is not clear what market participants will choose to do with legacy contracts that have not hit their end date. For contracts that allow both the index and margin to be changed, it is possible financial institutions will move to SOFR. For these, the margin can be adjusted to achieve a similar rate to Libor plus the margin applied to Libor. However, for contracts that only allow for the index to change or which are silent, use of SOFR with the margin in the contract would result in a lower rate. It is possible financial institutions will consider another index that is closer to Libor in these situations.

A checklist for preparation

  1. Establish a project team—including legal and compliance—to prepare for the shift.
  2. Identify the bank’s products, risk models, systems and documentation currently using Libor.
  3. For legacy loans that have not reached their end date:
    • Collect and review fallback language and determine how far back will be necessary. This will depend on the remaining term on legacy contracts.
    • Decide which index and margin to use. Consider whether different approaches are needed based on fallback language variation across products.
    • Decide whether to seek amendments through agreement from borrowers.
    • Consider ways to reduce litigation risks.
    • Based on the approach taken with legacy loans, plan to adjust financials accordingly.
  4. For loans executed in the future:
    • Decide which index and margin to use.
    • Decide whether to adopt the ARRC's recommended fallback language.
  5. Plan for communications both internally and to borrowers (educational, potential contract amendments and notification of the index change).
  6. Prepare to report to regulators on Libor transition preparedness.

Chris Heine, JD, CRCM is a principal consultant in Wolters Kluwer’s Compliance Center of Excellence group. As an attorney with more than 18 years at Wolters Kluwer, she uses her compliance expertise to help financial institutions meet the regulatory requirements that accompany the creation and implementation of loan documents, new product lines and expansions of existing ones.

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