Leaving LIBOR: 4 things to know about changing interest rate benchmarks
August 26, 2020
The country’s banking industry will transition to an alternative interest rate benchmark slated for launch on January 1, 2022. One strong possible replacement is SOFR (Secured Overnight Finance Rate). In the past, SOFR has only been used as a benchmark for short-term loan issuance, but a few banks are already using it in new instruments with loan terms of five years or longer.
Here are four things to know how about the pending transition, and how it may affect you and your existing bank loans.
LIBOR is exiting because of vulnerability to manipulation.
LIBOR rates are determined by surveys of large international banks and serve as the current reference rate for various floating commercial and financial contracts. By 2014, concerns about LIBOR manipulation led to the development of the Federal Reserve’s Alternative Reference Rates Committee (ARRC), charged with implementing a new rate calculation standard.
Measuring borrowing backed by U.S. Treasuries, SOFR is thought to be more reliable.
SOFR would play the same critical role that LIBOR occupies today as the basis that lenders use when they calculate a new interest rate or adjust an existing floating rate. But rather than LIBOR’s large bank rate surveys, SOFR is based on secured, daily-weighted lending rates from the repurchase or repo markets – a type of short-term borrowing for dealers in government securities. SOFR rates represent $1 trillion worth of daily transactions collateralized by U.S. Treasuries. These factors make the rate transparent and protect it from manipulation. However, because SOFR is a fairly riskless rate, an additional credit spread would need to be added to SOFR to make it comparable to LIBOR rates today.
Significant fallback language is critical to business contracts and loan terms.
Numerous domestic and international legal and financial contracts incorporate LIBOR. Fortunately, many existing floating rate notes and collateralized loan obligations already have existing fallback language within their product’s legal documentation that stipulates what happens should LIBOR become unavailable. Given the long run-up to a new benchmark rate, the transition to a LIBOR alternative should be a smooth one for borrowers.
Managing the benchmark rate transition at Alliance Bank of Arizona.
As the industry moves closer to adopting SOFR or an alternative rate benchmark, the transition will not be something bank customers need to monitor. At Alliance Bank of Arizona we’ve created governance and working committees to address the transition across our organization and have identified critical points where we know changes will be required. It’s very possible your loan documents won’t need to change, but we’ll be in touch if this is needed.
As always, please feel free to contact your Relationship Manager if you have questions about the transition from LIBOR to an alternate interest rate benchmark. We’re on top of these changes and we’ll communicate more details with customers as the official transition date approaches.