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. LIBOR is ubiquitous among loans, interest rate swaps, and other financial products.
Why should I care about LIBOR?
You or your company may have entered into a loan, and in some cases an interest rate swap, with First Business Bank in which your interest or floating rate payments are based on LIBOR.
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, U.S. and all 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 clients 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 the vast majority of banks and other market participants in the U.S. are expected to rely on SOFR as a replacement for LIBOR.
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 a number of ways, including that SOFR is a secured rate (LIBOR is unsecured), it is a compounded overnight rate (LIBOR is a term rate), and the two rates are based on entirely different markets. Because of this, when LIBOR is replaced by SOFR, banks and clients will make a mathematical adjustment, published by Bloomberg, to account for the fact that these two benchmarks are based on different metrics.
How will replacing LIBOR actually work?
Bilateral and Syndicated Loans:
For LIBOR-based loans that extend past 2021, robust “fallback” terms will need to be included in the loan documents to ensure that a valid interest rate governs loan documents when LIBOR is no longer a viable index. These fallback terms must include:
- The triggering events that will lead to LIBOR being replaced (including the index no longer being published, or the FCA determining that LIBOR is no longer “representative” of the underlying market);
- The LIBOR replacement rate (such as 30-Day Average SOFR, Daily Simple SOFR, the Effective Federal Funds Rate or the Prime Rate), plus any mathematical adjustment to the replacement rate; and
- The effective date on which LIBOR will be replaced with a new rate.
If a loan is hedged, it is generally in both the borrower’s and lender’s interest that the interest rate in the loan remains the same as the interest rate in the related interest rate swap, so that LIBOR is replaced at the same time and with the same replacement rate in the loan and the swap. As a result, hedged loans that reference LIBOR may include language stating that the LIBOR replacement terms set forth in the related interest rate swap (including the replacement rate, any adjustment thereto, and the timing of the replacement) will apply to the loan as well.
Swaps and Other Derivatives Transactions:
Unlike loans, an industry-wide, streamlined solution to replace LIBOR exists for derivatives transactions. The International Swaps and Derivatives Association or “ISDA” has created a dual-pronged approach to insert robust LIBOR fallback terms in all derivatives, and this includes (i) an amendment to the 2006 ISDA Definitions, which automatically applies to derivatives transactions executed on and after January 25, 2021, and (ii) a protocol incorporating such amendments into derivatives transactions executed prior to January 25, 2021.
The fallback terms that will be inserted into derivatives transactions via the ISDA amendment and Protocol state that when LIBOR stops being published by the ICE Benchmark Administration, or when the FCA has determined that LIBOR is no longer representative of the underlying London interbank market, LIBOR will be replaced by compounded SOFR plus a mathematical adjustment published by Bloomberg.
What Do I Need to Do Now?
Every LIBOR-based credit facility and interest rate swap that extends beyond 2021 will need to include robust fallback terms to account for the transition away from LIBOR. Without these fallback terms, there is significant uncertainty and the potential for disagreement between loan parties on how to replace LIBOR when it stops being published or is deemed as no longer “representative” by the FCA.
Each client will need to work with First Business Bank to ensure that its LIBOR-based loans and derivative transactions, whether already executed or to-be-executed, incorporate the appropriate fallback terms. To accomplish this, First Business Bank will contact our clients to (i) execute simple bilateral amendments to existing loan documentation, (ii) adhere to the ISDA protocol (discussed above), and (iii) insert the appropriate LIBOR fallback terms in new loan documentation.
Please contact us or your First Business Bank Relationship Manager to start the conversation.CONTACT US