Although the shift from LIBOR to a new reference rate is several years away, banks should start preparing today.
Syndicated loans make up only 1.7% of the nearly $200 trillion debt market that is tied to the London Interbank Offered Rate (LIBOR), a figure that includes derivatives, loan, securities and mortgages. But many banks hold syndicated loans on their balance sheets, and will be directly affected by efforts to replace LIBOR with a new reference rate.
In 2014, federal bank regulators convened the Alternative Rates Reference Committee (ARRC) in response to the manipulation of LIBOR by banks during the financial crisis. In 2017, the ARRC identified the Secured Overnight Financing Rate (SOFR) as the rate that represents best practice to replace LIBOR in USD derivative and other financial contracts.
Shifting from LIBOR to SOFR requires various moving pieces to converge as well as addressing legacy issues for existing contracts tied to LIBOR. The ARRC was reconstituted in 2018 with an expanded membership that includes regulators, trade associations, exchanges and other intermediaries, and buy side and sell side market participants. The group now oversees the implementation of the Paced Transition Plan and coordinates with cash and derivatives markets as they address the risk that LIBOR may not exist beyond 2021. This includes minimizing the potential disruption associated with LIBOR’s potential phase-out and supporting a voluntary transition away from LIBOR.
In April 2019, the ARRC released proposed fallback language that firms could incorporate into syndicated loan credit agreements during initial origination, or by way of amendment before the cessation of LIBOR occurs.
Contracts need recommended fallback language to provide consistency across products and institutions. The definition of LIBOR, the trigger events that would require use of the fallbacks and the fallbacks themselves vary significantly – even within the same product sets. Additionally, existing contractual fallback language was originally intended to address a temporary unavailability of LIBOR, like a glitch affecting the designated screen page or a temporary market disruption, not its permanent discontinuation. Until recently, fallback language rarely addressed the possibility of the permanent discontinuance of LIBOR. As a result, legacy fallback language could result in unintended economic consequences or potential litigation.
The ARRC recommends contracts have two sets of fallback language for new originations of U.S. dollar-denominated syndicated loans that reference LIBOR. Syndicated loan fallback provisions try to balance several goals of the ARRC: flexibility and clarity.
- “Hardwired Approach:” This approach uses clear and observable triggers and successor rates with spread adjustments that are subject to some flexibility to fall back to an amendment if the designated successor rates and adjustments are not available at the time a trigger event becomes effective.
- “Amendment Approach:” This approach is meant to offer standard language, which provides specificity with respect to the fallback trigger events and explicitly includes an adjustment to be applied to the successor rate, if necessary, to make the successor rate more comparable to LIBOR. It also includes an objection right for “Required Lenders.” In the Amendment Approach language, all decisions about the successor rate and adjustment will be made in the future.
As the market continues to prepare for LIBOR’s eventual exit, there are several steps that BancAlliance recommends that banks take to prepare for this transition:
- Quantify, document and monitor exposure to loans in your portfolio with LIBOR-based pricing.
- Ensure that executives are familiar with the current LIBOR fallback language in the individual credit agreements within the portfolio.
- Be mindful should any amendments occur to your existing portfolio, as SOFR’s acceptance grows in the marketplace.
- Continue observing new originations to see how fallback language is being drafted, and any other structural changes with regards to LIBOR.
- Review ARRC pronouncements and market-related current events to ensure your institution is up to speed on the latest news and changes with respect to LIBOR.