On July 27, 2017, Chief Executive of the United Kingdom (U.K.) Financial Conduct Authority (FCA) Andrew Bailey announced the FCA’s plan to eliminate the London Interbank Offered Rate (LIBOR) by the end of 2021.
Numerous lending institutions use LIBOR to calculate interest rates for various debt obligations, using the rate as a market rate for unsecured wholesale term lending to banks. Several banks submitted this rate, stating the interest rate they would offer to other banks for unsecured wholesale lending. However, in recent years, the amount of unsecured lending between banks has reduced, resulting in an inactive market.
The FCA cites the lack of availability of a market for the interest rate as the reason for terminating LIBOR. The FCA noted in recent years the banks that submitted the LIBOR rates were using “expert judgment” in determining the rate, given they weren’t actively lending to that market. Due to LIBOR’s large effect, the FCA determined a rate based on “expert judgment” isn’t representative of the market it’s trying to serve. Rather, the FCA wants to establish new benchmarks related to active markets to more accurately represent market rates.
The FCA noted the alternative interest rates will fluctuate from country to country. The Working Group on Sterling Risk-Free Reference Rates in the U.K. selected the Sterling Overnight Index Average (SONIA). This benchmark represents the overnight funding rates in the sterling unsecured market.
The U.S. established the Alternative Reference Rates Committee (ARRC) to determine the new alternative benchmark. ARRC worked with the Federal Reserve Bank and Office of Financial Research to determine the preferred benchmark. It chose a broad U.S. Department of the Treasury repo financing rate as an alternative.
Banks’ Next Steps
LIBOR’s elimination will affect new loans and swaps with maturity dates before 2021. For loans and swaps with maturity dates before 2021, a new reference rate, such as the aforementioned repo financing rate, is recommended as a substitute benchmark to facilitate the transition from LIBOR. For new loan swaps with maturity dates extending past 2021, the lenders should evaluate new benchmarks. If lenders use LIBOR as the benchmark for new loans, the new loan documents should specify an alternative benchmark or state the lender is permitted to change the benchmark to a comparable rate. In either case, the loan document should clearly indicate the change. Lenders should review existing loans extending past 2021 to determine if an alternative benchmark exists. If the loan documents don’t specify an alternative benchmark, the lenders should file an amendment to state the alternative benchmark.
The FCA acknowledges LIBOR’s global effect and understands the phaseout will take significant time and resources. As such, it gave a deadline of December 31, 2021. Until then, the FCA has asked lending institutions to continue submitting LIBOR rates using their expert judgment to keep LIBOR active through the phase-out date.
Contact your BKD advisor for more information.