The upcoming dissolution of the London Interbank Offered Rate (LIBOR) by the end of 2021 impacts all borrowers and banks that use LIBOR as a base rate. First Business Bank plans to choose a replacement for LIBOR by the latter half of 2021. One option under consideration is the Secured Overnight Funding Rate (SOFR). First Business Bank will reach out to clients about this transition. In the meantime, here are helpful answers to frequently asked questions.
What is LIBOR?
The London Interbank Offered Rate or “LIBOR” is a variable interest rate and financial benchmark, based on the rate at which banks lend to one another on an unsecured basis in the London interbank market. It is universal among loans, interest rate swaps, and other financial products.
How does the dissolution of LIBOR impact me?
In 2017, the UK Financial Conduct Authority or “FCA” (the regulator with authority over LIBOR), announced that after 2021, it will no longer require banks to submit the pricing information on which LIBOR is based. Therefore, worldwide financial markets will no longer be able to rely on LIBOR as a benchmark after 2021, and as a result, First Business Bank and its customers will need to replace all references to LIBOR in existing contracts that go past that date, and on a going-forward basis.
What will replace LIBOR?
Following the FCA’s announcement about the transition away from LIBOR, the Alternative Reference Rate Committee or “ARRC” (a public-private working group convened by the U.S. Federal Reserve) recommended the Secured Overnight Financing Rate or “SOFR” as a replacement for LIBOR in the U.S.
There is no requirement to adopt SOFR, but most banks and other market participants in the U.S. are expected to replace LIBOR with SOFR. First Business Bank plans to decide in the latter half of 2021.
What do I need to know about SOFR?
SOFR is a broad measure of the cost of borrowing cash overnight, collateralized by U.S. Treasury securities in the repurchase (repo) market. SOFR differs from LIBOR in several ways: SOFR is a secured rate (LIBOR is unsecured), it’s compounded overnight rate (LIBOR is a term rate), and the two rates are based on different markets. Because of this, if SOFR replaces LIBOR, banks and clients must make a mathematical adjustment for the fact that these benchmarks are based on different metrics.
How will replacing LIBOR work?
For LIBOR-based loans extending past 2021, certain “fallback” terms will be included in the loan documents, creating a mechanism for First Business Bank to choose a replacement rate for LIBOR upon the occurrence of certain triggering events, including the dissolution of LIBOR. Following any such event, First Business Bank and clients will execute an amendment setting forth the LIBOR replacement rate and any mathematical adjustment that will apply to the loan on a going-forward basis.
In LIBOR-based interest rate swaps and other derivative instruments, the International Swaps and Derivatives Association or “ISDA” is expected to publish (i) amendments to the 2006 ISDA Definitions and (ii) a protocol incorporating such amendments into already-executed swaps and other derivative transactions. The effect of this dual-pronged approach will be a streamlined insertion of fallback terms, allowing for SOFR to replace LIBOR (plus a mathematical adjustment) following the occurrence of certain triggering events. While not required, most swap market participants are expected to adhere to the ISDA protocol. First Business Bank will contact swap clients with more information.
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