By Robert Downs is Senior Principal Product Manager at Finastra
The London Inter-bank Offered Rate, or ‘LIBOR’, is often referred to as the “world’s most important number”, being deeply ingrained in lending markets worldwide. It dictates the interest rates for a huge percentage of consumer, commercial and syndicated loans, and is hardwired into financial derivatives internationally. LIBOR was first established in 1986, and today 97% of syndicated loans reference LIBOR in the US alone, with an outstanding volume of approximately $3.4 trillion. To top it off, LIBOR serves seven different maturities and is based on five currencies: USD, EUR, GBP, JPY, and CHF, meaning there are 35 different LIBOR rates published each business day.
As we move closer to the phase-out deadline of LIBOR in 2021 announced by the FCA back in 2017, its omnipresence in the market means the transition away from LIBOR could be extremely disruptive if banks and financial firms aren’t prepared. In this article, I will outline some key considerations and preparations for banks moving into a post-LIBOR world.
Multiple ‘risk-free rates’ (RFR) will take LIBOR’s place, comprised of benchmark rates originating from the US, the UK, Europe, Switzerland and Japan. Each has unique characteristics in currency, posting timing, security and underlying sources of data. Ultimately, this will lead to a high level of complexity for banks that have various loan instruments on their books. Depending on the jurisdiction, these RFRs may be any of the following:
- Pound Sterling (£) SONIA (Sterling Overnight Index Average)
- US Dollar ($) SOFR (Secured Overnight Financing Rate)
- Swiss Franc (CHF) SARON (Swiss Average Rate Overnight)
- Japanese Yen (¥) TONAR (Tokyo Overnight Average Rate)
Moving away from LIBOR to these overnight RFRs will create multiple financial and operational challenges for borrowers, lenders and agents. For example, an overnight RFR does not compensate the lender for bank credit or term risk, whereas LIBOR includes a premium on longer-dated funds. Additionally, moving to an overnight RFR would require treasurers to keep extra cash reserves to respond to movement in the interest rates.
Banks must prepare for a period where some deals remain linked to LIBOR while others will have transitioned to a new RFR, depending on the jurisdiction of the instrument. This challenge will be particularly applicable to commercial and syndicated lenders that operate cross-border. It will also be vital that banks and participants familiarize themselves with the publication timings of each rate. Today, LIBOR is published as of 11:00 GMT across each currency; however, other RFRs are published at different times throughout the day, which may cause complications.
Multi-currency complexity preparation
Cross-border lenders will need to consider potential operational impacts of using RFRs denominated in different currencies. The most convenient element of LIBOR is that it is quoted on the same basis for each LIBOR currency, whereas RFRs are generally currency-specific. Therefore, there is potential for issues in the loan market when drawings in different LIBOR currencies under the same facility are priced at the same margin. If different RFRs are used for different currencies, it may require a different margin per currency, which could create added complexity for borrowers and lenders. This can be particularly true for syndicated loans, which are often structured using multiple currencies.
A closer look at fallback language
Familiarization of existing fallback language and a proactive approach to addressing the way it will be updated to reflect a post-LIBOR world will be essential for lenders and borrowers.While there are fallback clauses in place within loan contracts, if there is an underlying benchmark unavailable for temporary technical reasons, existing fallback language may no longer be suitable long-term. In line with this,agent banks and lenders will need to review existing fallback language and make necessary adjustments in anticipation of variables stemming from new benchmark rates. Contract fallback language should allow for a spread adjustment to minimize valuation changes. Suggested contract fallback language should also include specific triggers that enact the shift to successor rate(s). It will be vital that the choice of a new benchmark rate, spread adjustment and the timing of the transition is clearly communicated to all borrowers and lenders involved.
There will need to be considerations of time and cost implications associated with amending and renegotiating each individual loan agreement to a new mutually agreed upon benchmark. It will also be important to consider how new clauses and potential wording can be operationally managed without introducing additional overhead and processing costs.
Engaging with lenders and borrowers
During the transition, minimizing business disruption should be a top priority. Agent banks should aim to anticipate any potential communication issues with syndicated lenders and create a cross-functional plan to avoid any disruption. Each loan agreement linked to LIBOR may need to be redrafted and agreed upon by the borrower, agent, and lender(s). It is critical that this communication is efficiently managed and documented, because if the new rate being adopted is higher or lower than LIBOR, there will be winners and losers in any renegotiation. This raises the potential for costly disputes and business disruption. If the new rate differs substantially enough from LIBOR,the likelihood for disagreement is high.It will therefore be essential to have risk mitigation strategies and communications plans in place.
The global lending market will undoubtedly face significant disruption over the next 36 months and beyond. The disruptive nature of the LIBOR transition is further amplified by the fact that several key elements are missing: a centralized coordination of currency working groups around the rollout, the adoption of forward-looking term rates, standardized fallback language and proactive communication. Though many institutions are already taking a proactive approach to making the shift before LIBOR completely phases out, this won’t be as easy as simply flicking a switch. Banks will need to work proactively and efficiently to streamline operations ahead of the changeover to ensure a smooth transition for itself and all loan participants.