The financial industry is in the process of a transition from the London Interbank Offered Rate (“LIBOR”) to an alternative benchmark interest rate. This change will impact the majority of loans, leases, contracts, and swaps with LIBOR references that mature after the LIBOR cessation dates.
Historically, LIBOR has been used as a benchmark for setting interest rates. LIBOR is used to help set the rates on commercial loans, derivatives, bonds, student loans, mortgages, and various other financial products. An estimated $200 trillion in commercial loans, derivatives, variable rate mortgages, auto loans, credit cards, and other financial products are tied to LIBOR interest rates.
However, LIBOR is being eliminated over the next 2 years and will need to be replaced with alternative reference rates (“ARRs”).
What is LIBOR?
LIBOR is an interest rate index provided on a daily basis by selected international banks. These banks report their cost to borrow from other banks on an unsecured, short-term basis for terms ranging up to one year. If there are insufficient interbank transactions to provide an accurate borrowing rate for each interval, the cost does not have to be based on actual borrowing transactions and may be estimated within defined parameters. These daily individual bank reports are combined and an index is published for each term and for each currency. The 2008 financial crisis revealed LIBOR's lack of transparency and vulnerability to manipulation. Further, over time as the number of interbank transactions has decreased, reporting has relied more heavily on subjective judgments.
What’s the future of LIBOR?
In July 2017, British regulators at the Financial Conduct Authority (“FCA”), who have primary responsibility for supervising LIBOR, announced that they intended to phase out LIBOR by the end of 2021. The stated goal is to transition from LIBOR to a new reference interest rate index that is based primarily (if not exclusively) on actual borrowing transactions. The U.S. Federal Reserve System, the U.S. Commodity Futures Trading Commission and a host of other U.S. banking and global financial regulators have voiced strong support for a transition away from LIBOR.
Industry groups like the Federal Reserve Bank of New York's Alternative Reference Rates Committee (“ARRC”) and the International Swaps and Derivatives Association (ISDA) have been working to identify new reference rates based on observable transactions that represent actual market activity. The ARRC’s membership represents the very largest financial institutions. Regulators and certain industry groups also participate in the ARRC’s activity. The ARRC has recommended the Secured Overnight Finance Rate (“SOFR”) as an index to replace LIBOR in loans and other financial instruments. The Federal Reserve Bank of New York began publishing the SOFR rate in April 2018.
What Is SOFR?
SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities in the repurchase agreement (repo) market. SOFR differs from LIBOR in two key respects: SOFR is a single overnight rate while LIBOR includes rates of several tenors; and SOFR is deemed a credit risk-free rate while LIBOR incorporates an evaluation of credit risk. Additionally, SOFR is based on historical transactions whereas LIBOR is based on “expert judgment” from the panel banks. Currently, there is a daily simple SOFR and a compounded SOFR. On July 29, 2021, the ARRC formally recommended Term SOFR.
Other industry groups continue to explore index replacements in addition to SOFR. Some constituencies have objected to a transition to SOFR and have proposed different replacement benchmarks for LIBOR, such as AMERIBOR (supported by the AFX exchange and a large number of regional and community banks) and the Intercontinental Exchange (“ICE”) Bank Yield Index (supported by the current administrator of LIBOR).
What is the timing for the transition?
In July 2017, FCA, the regulator of LIBOR, announced that it will no longer require panel banks to submit rates for the calculation of LIBOR after 2021. Several panel banks have already stopped providing LIBOR submissions, making LIBOR unstable and less representative of the whole market it is intended to represent.
ICE, which is tasked with overseeing and publishing LIBOR rates, has publicly announced that they can no longer support the accuracy of LIBOR, and they will only support LIBOR, as a “trusted” index for 1-week and 2-month USD LIBOR, through December 31, 2021. As of March 2021, the FCA confirmed that the publication of LIBOR on a representative basis will cease after the following dates:
|U.S. LIBOR Settings||Cessation Date|
|1-week||December 31, 2021|
|2-month||December 31, 2021|
|Overnight/Spot Next||June 30, 2023|
|1-month||June 30, 2023|
|3-month||June 30, 2023|
|6-month||June 30, 2023|
|12-month||June 30, 2023|
On November 30, 2020, the Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency provided guidance that issuing new LIBOR contracts after December 31, 2021 could present safety and soundness risks to banks. Pacific Western Bank has ceased originating new LIBOR-based loans and other products as of July 1, 2021, subject to certain exceptions. We currently offer our clients SOFR.
How this affects you
Given the pending cessation of LIBOR, there is no guarantee that LIBOR will continue to be published for the entire term of any financial instrument that references this rate, including any loan or interest rate hedging product you may have with Pacific Western Bank.
A change to the methodology used to calculate LIBOR or the permanent discontinuation of LIBOR could have an economic impact on any financial products referencing that rate. The terms of a financial instrument may provide a process for establishing a fallback rate, but for certain types of financial instruments it is currently uncertain what that fallback rate would be or how it would be established. The discontinuation of LIBOR could also result in a mismatch between the fallback rate established in the relevant financial instrument and your other financial instruments, including transactions used to hedge the impacted transaction.
As the migration away from LIBOR presents risks to both creditors and borrowers, Pacific Western Bank will continue to monitor the situation. We recommend that you do the same. You should consider (with your professional advisors) how you may be impacted by these developments, including whether there are other available benchmark interest rates offered that you may wish to select and whether it is necessary to amend any of your existing documentation referencing LIBOR.
Effective July 1, 2021, Pacific Western Bank has substantially stopped using any LIBOR index on new loan originations, and is instead offering Prime, SOFR, or AMERIBOR based variable rate options.
Transition timing can be very deal specific, driven heavily by the unique language within the loan documents of each deal. However, regulatory guidelines provide a framework that every transaction must adhere to.
Existing LIBOR-based transactions with a term that extends beyond June 30, 2023 must be amended to transition to an alternative reference rate on or before that date. To prepare for the transition, we’ll be amending existing contracts to include "fallback" provisions. Fallback means contract provisions identifying circumstances that will prompt the transition from LIBOR to an alternative reference rate. These contract terms reduce uncertainty and allow your loan or other product to keep working after LIBOR phases out.
For existing hedged loans with a swap, cap, floor, collar, etc., your hedging agreement will also need to be amended. This can be accomplished by adhering to the International Swaps and Derivatives Association, Inc.’s (“ISDA”) 2020 IBOR (“Interbank Offered Rates”) Fallbacks Protocol, which incorporates fallback language for a replacement index and spread adjustment. You should consider its impact on your own business—but only after consulting with your own legal, tax, financing, and accounting advisors. New hedged loans will incorporate fallback language in the hedging agreement by adhering to the ISDA 2020 IBOR Fallbacks Supplement.
Still have questions?
If you have any further questions or would like additional information concerning the replacement of LIBOR, please contact your Relationship Manager and refer to this website for future updates.
You can also view ISDA’s 2020 LIBOR Fallbacks Supplement and Protocol for additional information.