What can banks do to prepare for the transition away from LIBOR?
- January 13, 2021
Balance Sheet Risk Management
Financial Institutions | Kennett Square, PA
Financial Institutions | Kennett Square, PA
SummaryIn this Elvis-inspired session for the New Jersey Bankers Association, Bob Newman and Todd Cuppia discuss the scheduled phaseout of LIBOR at the end of 2021, identify the roles and impact of key players apart of this transition, and discuss what banks need to start doing to prepare.
Why is LIBOR being phased out and what are the challenges that are being faced by bankers?
The cessation of LIBOR stems back to 2017 when the Financial Conduct Authority (FCA) announced that they would no longer compel panel banks to quote LIBOR beyond 2021. The move away from the benchmark was precipitated by the scandals that were in large part a result of the subjective judgement used to establish this rate. With SOFR likely to take LIBOR’s place for a large majority of transactions, the judgment that was required of panel banks in determining the rate will no longer be required.
While there has already been a lot of work done, there is still much to do in order to minimize business risks and prepare for the post-LIBOR landscape. It is very important for banks to educate and prepare themselves and their customers for this change in market paradigm.
There are several other benchmark rates that were in the running to replace LIBOR. In addition to SOFR, what is available?
SOFR is expected to be the primary index for transactions referencing a floating rate; however, the market has not yet developed a forward-looking term fixing, similar to LIBOR. Many financial institutions are keen to see this term market develop prior to SOFR's wholesale adoption in loan transactions. Market participants have explored alternative indexes like AMERIBOR, ICE Bank Index, and Prime in their transition from LIBOR. Regardless of any remaining uncertainty, decisions may need to be made before an alternative rate emerges as the next benchmark.
There was a coordinated announcement regarding LIBOR at the end of 2020 given by key market constituents involved in the transition. What is the impact of that message?
On November 30, 2020, the ICE Benchmark Administration (IBA) announced a December consultation on its intention to continue the publication of one-month LIBOR through June 30, 2023, allowing most legacy USD LIBOR contracts to mature, rather than need to convert. Immediately thereafter, the FCA, Alternative Reference Rates Committee (ARRC), International Swaps and Derivatives Association (ISDA), and Prudential Regulators (Fed, FDIC, OCC) publicly supported the consultation and idea of an extension.
Notably, the U.S. Prudential Regulators also encouraged banks to cease entering into new LIBOR-based contracts by or before the end of 2021. This has led to discussion of syndicated loans with the ARRC’s hardwired “early opt-in” language, which could allow lenders to transition LIBOR-based contracts if a specified number of USD syndicated loans reference SOFR. This could lead to LIBOR-based loans transitioning between December 31, 2021 (or even sooner, depending on how rapidly the SOFR market develops) and June 30, 2023, which may be attractive to banks, depending on any other steps that regulators might take to encourage them to transition as much of their LIBOR-based portfolio as possible in the near term.
What have ISDA and other agencies begun to do to help transition the swap market away from LIBOR?
Last year ISDA released their Fallbacks Protocol which inserts updated definitions into LIBOR for derivative contracts in hopes to minimize the economic risk associated with the transition. Accepting and adhering to the protocol is an important milestone for banks.
Additionally, the consultation that the ICE Benchmark Administration (IBA) is expected to be released in early 2021 which will hopefully address and answer some of the most complicated problems that are still unknown.
What should banks be doing now so that they are prepared?
There are a few things that banks need to consider
- Establish a firm action plan to ensure your bank's operational tools are ready to handle a new index rate
- Get comfortable with pricing loans with indices outside of LIBOR (SOFR, Prime, Fed Funds, etc.)
- Inventory exposure to LIBOR (in the loan and securities portfolio as well as funding and deposit products) and amend these documents as needed
- Begin lending against your institution's new, preferred rate
Interested in discussing the transition away from LIBOR and the impact on your financial institution? Contact us today.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.21-0035
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