The end of libor: Are you prepared?

LIBOR is retiring at the end of 2021 and SOFR is the replacement.

What once could have been argued as being one of the most important benchmarks in banking, LIBOR, is coming to an end. With a shelf life expiring at the end of 2021, what does this mean for investors and borrowers?

First, it is important to understand why the LIBOR is ending in 2021. LIBOR (London InterBank Offered Rate) is meant to represent the interest rate banks lend to one another. However, in July of 2012 it came to light that banks were manipulating the LIBOR for the purpose of profit. Banks had been falsely reporting interest rates, therefore impacting the LIBOR benchmark, and, in turn, borrowers overpaid on interest. The manipulation was easy for the banks because they were asked to report a hypothetical rate at which they could borrow, not the rate they actually borrowed.

In 2014 the Federal Reserve Board and the New York Fed created the Alternative Reference Rates Committee (ARRC), and tasked them with finding a more transparent and robust replacement for LIBOR as well as creating an orderly transition plan. In 2017, ARRC identified the Secured Overnight Financing Rate (SOFR) as the recommended replacement for US denominated transactions. SOFR is based on overnight transactions secured by the US Treasury securities and represents a risk-free interest rate.

Transitioning from LIBOR to SOFR: Potential challenges

The transition from LIBOR to SOFR will not be without some speed bumps. The first being that SOFR is quoted at a lower rate than LIBOR due to how it is derived, which means a straight transition from LIBOR to SOFR would result in a lower interest rate. LIBOR was based on unsecured transactions and therefore included a bank funding risk. To ensure compatibility, an adjustment spread will be required on SOFR.

Second, the majority of contracts use a forward looking index as the benchmark. For example, on mortgage loans the one-year LIBOR is typically used. A one-year LIBOR is an average of rates anticipated over the coming year based on a yield curve. SOFR is an overnight rate (backward looking) and a forward looking term SOFR is still in development. ARRC plans to publish a forward looking term rate at the end of 2021.

The third potential speed bump is preparing written contracts for the transition. Any new contract that extends past the retirement of LIBOR is recommended to use another benchmark or have fallback language if the LIBOR ceases to exist. Legacy contracts tied to LIBOR without fallback language that extend past 2021 will be more complicated. It is recommended to check the language of these legacy contracts to understand and quantify the exposure if LIBOR retires. Amending these contracts now will reduce litigation, but not without costs as well as the potential for the borrowers to disagree with the new terms.

Be prepared for the transition from LIBOR to SOFR

LIBOR is retiring at the end of 2021 and SOFR is the replacement. It is time to move from the denial phase to the acceptance phase and gear up for the move. Work still remains for the AARC committee, specifically in addressing term SOFR rates, but this is not an excuse to procrastinate any further. Are you prepared for the transition? Here are some things you should consider as you prepare:

• Do your current contracts include language to transition away from LIBOR?
• Will your systems and applications be able to support the transition?
• Is there a plan for legacy contracts that extend past 2021?
• Do you have an understanding on your legacy contract exposure?
• Is there a communication plan for impacted borrowers?

These are important questions to consider as banks prepare to transition from one of today's most important financial indexes.

What Is My Exposure?

Another important aspect of the transition from LIBOR to SOFR that banks should consider is understanding what their contract exposure may be. Understanding contract exposure with the LIBOR transition can be exhausting.

The first step is understanding the population of contracts your bank has that utilize LIBOR as the benchmark that will extend past 2021. An existing software platform could already contain this information which would make this step very easy. If this is not the case the contracts will require individual review.

The second step is to search for fallback language in the contract in the event the LIBOR ceases to exist. This fallback language can vary greatly and potentially increase exposure based on the fallback steps outlined. Most likely, this information is not easily accessible in a system, which means and individual contract review will be required.

However, contract review can be addressed with the use of Optical Character Recognition (OCR), AI, and machine learning. Technology has advanced in a way where some of the painfully manual processes can now be automated. This means that contracts can now be clustered into groups, and machine learning algorithms can be trained to search and find the information that is desired. What once could take thousands of man hours can now be performed by a machine in minutes.