With many LIBOR rates coming to an end in 2021, now is the time for financial institutions to start preparing for the transition, which means everything from reviewing contracts, identifying new reference rates, training your team, and understanding accounting relief.
Here are common questions and answers to guide you through the transition.
Why is LIBOR going away?
London Interbank Offered Rate (LIBOR) tenors have been around since 1986, serving as the most widely used benchmark interest rate in the world. The Intercontinental Exchange (ICE) has been publishing 35 different LIBOR tenors since 2014, made up of the following seven tenors for each of five major currencies — the UK pound sterling, the Swiss franc, the euro, the Japanese yen, and the U.S. dollar:
Each day, select large banks submit the estimated rate at which they think they could borrow unsecured funds from other large banks. The lowest and highest submissions are disregarded, and the average of the remaining rates is published as the LIBOR. At one time, these rates were based on actual activity.
Since the Great Recession, this activity has disappeared, which is why the rates are now estimated. As a result, schemes to manipulate LIBOR have been uncovered, and an overall loss of confidence in these rates has led to the demise of LIBOR.
What alternative reference rate should I use?
In the United States, the Alternative Reference Rates Committee (ARRC) was created to identify alternative rates that could replace U.S. LIBOR. In June 2017, the ARRC identified the Secured Overnight Financing Rate (SOFR) as its preferred replacement rate. SOFR is a broad measure of the cost of borrowing cash overnight, collateralized by U.S. Treasury securities, published by the Federal Reserve Bank of New York. It is based on actual trades in very active markets, minimizing the risk that the rate can be manipulated.
The SOFR overnight rate has been published since April 2018. Beginning in April 2021, CME Group began publishing SOFR term rates based on SOFR futures, and in July 2021, the ARRC formally recommended CME SOFR term rates.
SOFR has different characteristics than LIBOR, which means it will not behave exactly the same as LIBOR.
For example, SOFR is backward looking, while LIBOR is forward looking. Also, SOFR is a secured rate, while LIBOR is based on unsecured funding. Institutions should consider whether these differences will require changes in how the rates will be used in contracts (e.g., loans).
Other rates have begun to emerge as alternatives to U.S. LIBOR, such as the Bloomberg Short Term Bank Yield Index (BSBY) and AMERIBOR. However, such alternative rates have come under some scrutiny, since they may include some of the same shortcomings as LIBOR due to less active underlying markets.
When do I need to act?
Originally, the Financial Conduct Authority (FCA) announced it would no longer publish LIBOR beginning on January 1, 2022. However, in March 2021, the FCA stated it would continue to publish the following U.S. LIBOR tenors through June 30, 2023:
The extension of these rates likely occurred because an estimated $200 trillion of contracts in the United States are tied to these rates. Even so, institutions should not expect any further extensions and should begin planning for the necessary transition as soon as possible.
Banking regulators have also begun to communicate their expectations for moving away from LIBOR.
In SR 21-7, Assessing Supervised Institutions’ Plans to Transition Away from the Use of the LIBOR, the Federal Reserve laid out six key areas supervised entities should be addressing to prepare for the LIBOR transition. The communication also stated that entering into new contracts that reference LIBOR after December 31, 2021, would create safety and soundness risks.
Institutions should begin preparing for the LIBOR transition in earnest today if they have not begun to do so already.
How do I prepare for transition?
At a minimum, institutions should be doing the following to prepare for the transition from LIBOR:
1. Review existing contracts and agreements for the use of LIBOR
Each institution should identify all contracts it has that use LIBOR, which may include loans, securities, derivatives, debt and leases. Management should then determine whether the contract will mature after the applicable LIBOR will no longer be published. For these contracts, management must then verify whether fallback language is already included in the contract to prescribe what rate should be used if the contractual LIBOR is not available. If fallback language does not exist, the institution should consider amending the agreement with the other party(ies) to modify the rate immediately or to add appropriate fallback language.
2. Identify a new reference rate
Each institution should identify the replacement rate to be used for contracts that would otherwise use LIBOR. It appears SOFR will be the rate preferred by most entities, and regulatory bodies have communicated that this is the rate they expect will replace existing LIBOR. If an institution is considering using a different alternative rate, that institution should also consider what additional due diligence and documentation will be completed to support the rate.
3. Educate key team members regarding differences between the indices
Any alternative rate selected for future contracts will behave differently from existing LIBOR for the reasons discussed above. Management teams should spend time learning what those differences are and their potential impact on future rate changes.
4. Establish a date for the transition and develop and execute a plan to transition
As discussed above, the Federal Reserve has already published guidance that communicates its expectation that financial institutions will have transitioned to an alternative rate by December 31, 2021, despite the extension of the most common U.S. LIBOR tenors. Management teams should determine how quickly they want to make the transition and then develop a plan to accomplish this task.
5. Take advantage of practical expedients when accounting for the transition
The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2020-04, Reference Rate Reform (Topic 848), Facilitation of the Effects of Reference Rate Reform on Financial Reporting, to provide certain relief and practical expedients when accounting for changes to contracts due to the transition from LIBOR.
These optional expedients for contract modifications are available only when all of the contract modifications are related to the replacement of LIBOR because of reference rate reform. Note that these expedients are also available if the contract moves from LIBOR to the prime rate.
Following are the practical expedients and specific accounting guidance for contracts modified because of reference rate reform:
- Contracts within the scope of Accounting Standards Codification (ASC) Topic 310, Receivables, and ASC Topic 470, Debt, may be accounted for as a continuation of the existing contract. This would be done by prospectively adjusting the effective interest rate. For financial institutions, this covers loan agreements with customers and borrowing agreements with outside parties.
- Contracts within the scope of ASC Topic 840 or 842, Leases, may be accounted for as a continuation of the existing contracts, with no reassessment of the lease classification and the discount rate or remeasurement of lease payments that otherwise would be required under these topics for modifications not accounted for as separate contracts.
- The ASU provides an exception to ASC Topic 815, Derivatives and Hedging, to allow a hedging relationship to continue without de-designation for certain changes in the critical terms of a hedging relationship. An entity may change the reference rate or other contractual terms of a hedging instrument, a hedged item or a forecasted transaction designated in a fair value hedge, cash flow hedge or net investment hedge, as applicable, so long as the changes are due to reference rate reform.
- For other ASC topics or industry subtopics, the ASU includes a general principle that entities may consider in-scope contract modifications as events that do not require contract remeasurement or reassessment of previous accounting determinations.
How Wipfli can help
Our financial institutions team is available to help with your transition from LIBOR or for help navigating this process. Contact us today.