Note: This is a follow-up to an article published in February 2020 that provided background on what motivated the movement away from the London Interbank Offered Rate (LIBOR) and included information on preparing for the transition to another benchmark rate.
Key points:
- The end of LIBOR as a benchmark for new lending is less than five months away. Although progress has been made, substantial work remains for some firms to complete the transition to an alternative benchmark by December 31, 2021. The transition requires immediate action.
- Failure to adequately prepare is a threat to overall financial stability and exposes individual firms to safety and soundness risks. It is imperative that firms cease offering LIBOR products and select an alternative reference rate as soon as possible. Institutions should also adopt fallback language for contracts that mature after the cessation of LIBOR.
- While market participants are not required to select the Secured Overnight Funding Rate (SOFR) to replace LIBOR, the Alternative Reference Rate Committee (ARRC)—which was convened by the Federal Reserve and includes representatives from financial regulatory agencies as well as market participants—recommends selecting SOFR, which has a much deeper, more liquid market that better reflects current funding practices.
- Recent actions to create a SOFR term rate will facilitate the transition from LIBOR to SOFR. Regulatory officials urge institutions to use the new term rate to accelerate their preparation for the end of LIBOR.
- The Federal Reserve urges institutions it supervises to communicate with examiners and refer to Supervision and Regulation letter 21-7(Assessing Supervised Institutions' Plans to Transition Away from the Use of the LIBOR) and Supervision and Regulation letter SR 21-12 (Answers to Frequently Asked Questions on the Transition Away from London Interbank Offered Rate). The Board's public website offers additional information.
- Federal Reserve examiners are currently assessing institutions' preparedness for the end of LIBOR through examinations and other supervisory activities. Firms that are unable to demonstrate sufficient progress toward an orderly transition on December 31, 2021, may be subject to supervisory findings and actions.
LIBOR cessation and exposure
In March 2021, the UK's Financial Conduct Authority (FCA) confirmed that the production of one-week and two-month U.S. dollar (USD) LIBOR settings would cease immediately after December 31, 2021. Publication of the overnight and one-, three-, six-, and 12-month USD LIBOR settings will end on June 30, 2023, to allow time for existing contracts to mature.
In 2017, when the FCA first announced that LIBOR production would cease after 2021, the intervening period—from 2017 through 2021—was intended to allow a smooth transition to alternative benchmarks. However, according to the ARRC's March 2021 report, "The Transition from the U.S. Dollar LIBOR," the estimated USD-denominated LIBOR exposure has grown from $200 trillion in 2017 to a current $223 trillion. Of this amount, an estimated $74 trillion matures after June 30, 2023. The report also identified certain products, such as business loans, where the use of LIBOR has not diminished.
One of the ongoing concerns regarding the use of SOFR as an alternative to LIBOR has been the lack of forward-looking SOFR term rates. Two recent actions have been taken to address this concern:
- On July 26, 2021, the Commodity Futures Trade Commission implemented the SOFR First initiative, switching interdealer trading conventions from LIBOR to SOFR for all linear interest rate swaps. This move increased the volume of transactions quoted in SOFR, an important market precedent for the recommendation of term rates.
- On July 29, 2021, based on the success of the SOFR First implementation, ARRC formally recommended the use of the SOFR term rate as a replacement for USD LIBOR, remedying what had been a stumbling block for market participants. This action provides market participants with an essential tool needed to complete the transition away from LIBOR.
Supervisory response
Since the FCA's original announcement in 2017, financial regulators have emphasized the challenging task that institutions face in transitioning to an alternative reference rate. Supervisors have also warned of the possible consequences of insufficient preparation, including exposure to substantial operational, legal, and reputational problems and, ultimately, the stability of the financial system. Although institutions have made progress in assessing their exposure to LIBOR and considering alternative reference rates, LIBOR remains used in new contracts. In addition, some firms have also been slow to adopt compensating fallback language in existing contracts to provide for a smooth transition.
In November 2020, the Federal Reserve Board issued a statement supporting a path forward for the transition of LIBOR—including a clear end date for USD LIBOR—that would protect the safety and soundness of the financial system. U.S. financial regulators also issued a joint statement that explained safety and soundness risks associated with the continued use of USD LIBOR in new transactions after 2021. Separately, the agencies reiterated that banks can choose any reference rate that they determine to be appropriate for their funding models and customer needs.
Many market participants continue to look to credit-sensitive alternatives to SOFR, such as the Bloomberg Short-Term Bank Yield Index or Ameribor. However, ARRC recommends the use of SOFR in place of LIBOR. In contrast to LIBOR, SOFR is based on overnight Treasury repurchase agreement transactions, a much deeper, more liquid market that better reflects current funding practices. During the Financial Stability Oversight Council's meeting on June 11, 2021, official participants emphasized the urgent need for accelerated efforts to provide a smooth transition to a new benchmark rate and endorsed SOFR as the preferred alternative reference rate, citing its strengths compared to LIBOR.
As Federal Reserve vice chair Randal Quarles noted, "The broad range of private-sector market participants who constitute the ARRC constructed and chose SOFR as their preferred rate precisely because of this stable structure.
"It is transparently calculated, engendering market confidence," he added. "For all these reasons, the ARRC did not recommend rates other than SOFR in capital markets or for derivatives, and market participants should not expect such rates to be widely available. For non-capital markets products, our supervisory guidance clearly notes that lenders and borrowers are free to choose among rates that meet their needs, but there are benefits of SOFR for these products, and thus—particularly with the development of term rates—SOFR will play a role in these markets as well."
Assessing transition preparation
On March 9, 2021, in response to FCA's confirmation of its plan for the cessation of LIBOR, the Board of Governors issued Supervision and Regulation letter 21-7 ("Assessing Supervised Institutions' Plans to Transition Away from the Use of the LIBOR"), which is applicable to all firms supervised by the Federal Reserve. The letter outlines the factors that examiners will consider in assessing aspects of transition efforts and includes separate examination guidance tailored for banks with under $100 billion in total consolidated assets (which generally have less material and less complex LIBOR exposures) and those with $100 billion or more in total consolidated assets (which generally have more significant and complex LIBOR exposures and should develop more detailed transition plans). The letter notes that examiners should consider issuing supervisory findings or taking other supervisory actions if a firm is not prepared to adopt an alternative benchmark by December 31, 2021.
As Vice Chair Quarles noted in March 2021, "Examiners are looking closely to see whether firms have comprehensively assessed their exposure to LIBOR and, if exposures are sizable and complex, have strong plans in place." In that speech, he went on to note six key areas that firms should prepare for the LIBOR transition:
- Transition plan: The detail and scope of each firm's transition plans should be commensurate with its LIBOR exposures. Large firms should have a LIBOR transition plan with defined timelines, a governance structure that clearly defines roles and responsibilities, and an appropriate budget and resources to support the plan.
- Financial exposure and risk assessment: Each firm should accurately measure its financial exposures to LIBOR and report them to senior management. Large firms should measure their exposures frequently—for example, quarterly—identifying exposures by product, counterparty, and business line and identifying the proportion of exposures that will run off before the relevant LIBOR tenor ceases.
- Operational preparedness: Each firm should identify any internal and vendor-provided systems and models that use LIBOR as an input and make necessary adjustments to provide for their smooth operation ahead of LIBOR's cessation.
- Legal contract preparedness: New LIBOR contracts should have robust fallback language that includes a clearly defined alternative reference rate, and each firm should develop a plan regarding the steps it will take to modify any contracts that may be negatively affected by LIBOR's cessation.
- Communication: Communication with customers and counterparties is especially important and should be an area of keen focus during 2021. Commensurate with its exposures, each firm should communicate to its counterparties, clients, consumers, and internal stakeholders about the LIBOR transition. Each firm should ensure compliance with requirements of the Truth in Lending Act and other applicable laws and regulations.
- Oversight: Finally, each firm should provide regular updates to senior management. Large firms should provide timely updates to the board of directors, and the board should hold senior management accountable for effectively implementing the firm's plan.
In the speech, Quarles also said, "While we will examine against all these points, what is most important this year is that firms should end new use of LIBOR."
To assist supervised firms' transition away from LIBOR, the Federal Reserve has issued Supervision and Regulation letter 21-12, ("LIBOR Transition Frequently Asked Questions"). The letter will be updated as needed, and institutions are encouraged to check the Board's public website for new information or revisions to existing FAQs.
Dealing with outstanding issues
Although the continued publication of certain USD LIBOR tenors until June 2023 will allow time for more contracts to mature, ARRC estimates that some $74 trillion of USD LIBOR exposure will remain. Most of this exposure consists of derivatives, which may be addressed using protocols of the International Swap and Derivatives Association. An estimated $1.9 trillion in exposures will remain in bonds and securitizations. While some of these contracts may have fallback language, others may have no effective means to transition away from LIBOR. Market participants, with the support of financial regulators, have asked Congress to provide a legislative solution for these types of "tough legacy contracts."
Conclusion: Preparation now eases transition later
Firms should carefully consider which alternative reference rate they select and take immediate steps to ensure they are fully prepared for a smooth transition away from LIBOR, including halting the issuance of new LIBOR contracts and instruments and adding fallback language to existing contracts that mature after June 2023. Banks should reference SR Letters 21-7 and 21-12 to understand supervisory expectations and prepare quickly for a successful transition away from LIBOR by year-end. Institutions that are not ready to adopt a new benchmark as of January 1, 2022, will be examined accordingly.
Arati Batta, a senior examiner in the Atlanta Fed's Supervision, Regulation, and Credit Division