The London Interbank Offered Rate (LIBOR) is a global benchmark interest rate investors and banks use in credit agreements. It is calculated daily by a British regulator, using the average interest rate at which large, international banks around the world report they borrow unsecured funds from one another, and expressed in five different currencies. Since the mid-1980s, LIBOR has been used for nearly all commercial, consumer and mortgage loan products. The problem is that LIBOR is not set by the cost of funds that banks actually pay because the rates are collected through a self-reported survey of participating banks.
Although regulators expressed dissatisfaction with reliance on LIBOR in 2008 after the financial crisis, abuses became apparent in 2012 when regulations curtailed interbank lending. It was revealed that more than a dozen financial institutions falsely reported their data to reap bigger profits from LIBOR-based derivative products. Since then, regulators have assessed billions of dollars in penalties and fines. While banks have continued to participate in the LIBOR calculation survey, at the end of 2021, LIBOR will likely disappear.
The Federal Reserve Board and the Federal Reserve Bank of New York created the Alternative Reference Rate Committee (ARRC) to: identify alternative reference interest rates that are based on transactions in an underlying market and comply with emerging standards, establish best practices for contract quality, and develop an implementation plan. In 2017, the ARRC announced the Secured Overnight Financing Rate (SOFR) was chosen as the recommended LIBOR replacement.
The SOFR has been published daily since April 2018 to help U.S. banks begin the transition away from LIBOR when pricing U.S-dollar derivatives, commercial paper and variable rate consumer loan products including student loans and adjustable-rate mortgages. It’s a virtually risk-free rate based on actual transactions in the Treasury repurchase market, which had roughly 1,500 times the number of interbank loans as of 2018.
What does this change mean for banks? It means complex repricing processes for loans that used LIBOR and extend beyond 2021. Now is the time to focus on pricing new loans based on SOFR, coupled with a clear transition plan to mitigate risk from older contracts:
- Identify the extent of reliance on LIBOR up to and past 2021
- Quantify LIBOR exposure
- Assign senior management responsibility with key milestones to track progress and reports throughout the bank and to the Board
- Identify and manage the risks associated with a phase-out over time, rather than going “cold turkey” when LIBOR ends