It's Time for Community Banks to Address the End of LIBOR

The London Interbank Offered Rate (LIBOR) is going away. In July 2017, due to past manipulation of LIBOR, the UK Financial Conduct Authority (FCA) announced that it would no longer seek to compel banks to publish LIBOR after December 2021. This is a huge development. As of mid-2018, about $400 trillion worth of financial contracts used LIBOR as the reference rate. The FCA’s announcement has prompted a search for a new benchmark rate to replace LIBOR. Community banking institutions that use LIBOR in their consumer (e.g., home mortgages) or commercial portfolios will need to address how to transition their portfolios to a new benchmark rate.

The transition is not as easy as it may seem. The language in existing loan documents is frequently less than clear, and sometimes silent, about how a new benchmark rate should be selected and implemented. This lack of clarity raises significant litigation concerns relating to both consumer and commercial loans.

To help community banks prepare for the transition in the benchmark rate, Warner has established a LIBOR transition team.

How Banks Can Prepare for the Transition

In anticipation of the LIBOR transition and the need for a LIBOR replacement benchmark rate, your institution should recognize the primary concerns and take the following steps:

Identify Your Exposure. Understanding your institution’s exposure as a result of the LIBOR transition is a critical first step in establishing the changes your institution needs to make in its existing and future loans, as well as identifying potential litigation risks your institution faces. You should start by assessing your institution’s greatest vulnerabilities, such as existing loans and other contracts that currently reference LIBOR, including consumer mortgages, commercial loans and SWAP transactions. To facilitate this process, your institution may also consider establishing a LIBOR transition team.

Consider Potential Benchmark Replacements and Adjustments. Once you identify your exposure, you need to identify the potential reference benchmark rates and adjustments that are available to you. The United States Alternative Reference Rates Committee (ARRC) has proposed the Secured Overnight Financing Rate (SOFR) as the replacement for LIBOR; however, there are significant differences between the two benchmarks—namely, SOFR is a risk-free rate based on actual transactions, while LIBOR is based on unsecured transactions and traditionally relied on bank reports. You may also consider using the Prime Rate, Federal Funds Rate or other floating benchmarks as an alternative benchmark rate. Additionally, you will need to determine the margin that will be added to the benchmark for each affected loan to achieve a rate equivalent to the current rate based on LIBOR.

Amend Existing Contract Language and Establish New Contract Language to Handle Existing References to LIBOR. After determining the benchmark replacement and the related margin, your institution will need to develop new contractual language for your loan documents and a process for implementing a transition for the LIBOR loans currently in your portfolio. Your process will need to address how you are going to amend your current loans, which will frequently require getting the consent of your customer. The longer an institution waits to identify contracts and establish its transition language, the more difficult the transition will be for the bank.

Additionally, the International Swaps and Derivatives Association (ISDA) is currently developing standardized language for SWAPs to be entered after the LIBOR transition based on the SOFR, plus a currently unknown mathematical adjustment. Your bank needs to be prepared to implement new standardized language into your institution’s SWAP contracts once acceptable language is released.

Communicate With Customers and Execute Amendments. Your customers–especially consumer customers–may not be aware of the issues surrounding the transition away from LIBOR, and may not understand the after-effects of the transition. Therefore, you need to develop a communication strategy focusing on explaining the LIBOR transition and its implications, including presenting existing loan customers with loan amendments to handle the transition.

We’re Here to Help

For more information on the LIBOR transition and assistance on effectively handling the transition, please contact any member of Warner’s LIBOR transition team: Rodney Martin, Rob Davies, Charlie Goode, Kris Araya or Alex Chitwood.