What steps do you need to take when the benchmark interest rate changes?
The global financial industry is preparing to transition from a key benchmark interest rate — the London Interbank Offered Rate, or LIBOR — to new alternative rates. The current plan is for a cessation of LIBOR by the end of 2021. However, a revised timeline is being considered.
On November 30, 2020, ICE Benchmark Association (IBA), the administrator of LIBOR, proposed a two-phase approach to cessation, starting with one-week or two-month LIBOR by the end of 2021, with other LIBOR tenors (i.e., overnight, one-month, three-month, six-month, and 12-month tenors) potentially being published through June 30, 2023. Sean Faeth, managing director, Wells Fargo Private Bank, has been following the proposal closely. “The final timeline is expected to be set through resolution of the IBA proposal in the coming months. Notwithstanding final resolution of the LIBOR publication timeline, it is clear that the days of LIBOR are numbered as U.S. bank regulators have issued supervisory guidance that otherwise encourages banks to stop new U.S. dollar (USD) LIBOR contract issuances after 2021.”
Faeth offers more perspective on the transition. “LIBOR has long been the benchmark for interest rates across the globe, but over the past decade, fewer actual transactions supported the benchmark rate. Instead, participating banks increasingly used what was referred to as ‘expert judgment’ to set LIBOR, making it less credible. The need for a more transparent benchmark rate required changes on an international scale.”
For USD agreements, the new reference rate will be the Secured Overnight Financing Rate (SOFR). (For a more comprehensive list of reference rates being adopted, refer to Transition from LIBOR.)
While LIBOR is an unsecured interbank borrowing rate, SOFR is a broad measure of the cost of borrowing on a secured overnight basis with U.S. Treasury securities serving as collateral. It is determined by actual market transaction data compiled by the Federal Reserve Bank of New York. Faeth says, “We feel that this new benchmark provides a more reliable, sustainable index going forward.”
So what does that mean for high net worth investors and borrowers?
Understanding SOFR and other reference rates — and how this transition may impact new and existing LIBOR-linked agreements and contracts — is important for borrowers and investors.
If you have an adjustable rate mortgage or a custom or commercial loan, chances are some of your accounts may be tied to LIBOR, and certain investments you hold might use LIBOR as a benchmark rate. Among the agreements that may have LIBOR as a benchmark:
- Securities-based and unsecured lines and loans
- Commercial and consumer real estate loans
- Small business lines and loans
- Derivative contracts
- Large syndicated loans
- Multi-currency loans
Steps to take now
Faeth recommends consulting with your private banking or investment professional to help understand the new reference rates, review how these changes may impact your accounts, and outline a plan for addressing your borrowing needs in the future.
“Consider reviewing existing contracts in your next relationship meeting,” Faeth says. “For newer LIBOR-based contracts, ‘fallback language’ may have been included to describe the process for moving to a replacement rate when LIBOR is no longer available. However, contracts written before the LIBOR transition was announced may need to be amended to add ‘fallback language’ or to move directly to a new reference rate such as SOFR. In addition, an industry-consistent spread-adjustment methodology1 will be utilized to account for differences between LIBOR and SOFR. The goal within the industry is to minimize any transition impacts for all parties.”
The majority of the transition is expected to take place in stages over the next 12 to 36 months, subject to resolution of the IBA proposal reference above. Certain contracts, such as mortgages, may require that LIBOR ends before switching to another benchmark, so some transition will come at the end of that period. For more perspective on this transition, please review From LIBOR to SOFR—500 days and counting, a report from Wells Fargo Investment Institute.
1The Alternative Reference Rates Committee (ARRC) and The International Swaps and Derivatives Association, Inc. (ISDA®) have recommended a spread-adjustment methodology based on a historical median over a five-year lookback period of calculating the difference between LIBOR and SOFR.
The views expressed by the presenter do not necessarily reflect the views of Wells Fargo or its affiliates.
LIBOR transition risks
This information is not intended to override, and should be considered in conjunction with, any disclosures, or other statements identifying potential risks provided to you by Wells Fargo Bank. The events described in these Materials could have unpredictable and material consequences for transactions, products, and services that require payments or calculations to be made by reference to LIBOR. These consequences include, but are not limited to, the following:
- value change: changes to the way in which the relevant interest rate benchmark is calculated, or differences in the way a replacement alternative reference rate (“ARR”) is calculated, could materially affect the value, price, cost and/or performance of affected contracts;
- mismatches: the way in which and the time at which ARRs are introduced may differ across connected affected contracts such as loans and their related hedges or across underlying assets and bonds in a securitization, and those differences may create material economic mismatches and introduce basis risks;
- lack of certainty: some existing affected contracts may not provide any fallback language or contemplate a replacement rate; as such, there could be disputes about what replacement rate applies as and when the relevant interest rate benchmark is unavailable or is no longer representative, or whether contracts are enforceable in the absence of any replacement rate;
- development of new rates: new alternative rates are likely to be developed over time and these new rates may be materially different from both the relevant interest rate benchmark and replacement rates that are currently being considered;
- inability to use a rate in new products: existing or new regulations may limit the ability of market participants to enter into new transactions, products, or services linked to the relevant interest rate benchmark if a determination or announcement is made that such rate is no longer representative of the relevant market;
- selection of a replacement reference rate: Wells Fargo may have rights to determine a replacement rate for the relevant interest rate benchmark for affected contracts, including any price or other adjustments to account for differences between the replacement rate and the existing rate, and the replacement rate and any adjustments we select may be inconsistent with, or contrary to, your interests, expectations or positions;
- risks relating to risk-free rates: as ARRs are overnight rates (some of which have started to be published only relatively recently), there may be limited liquidity in the market for financial contracts referencing an ARR, uncertainty as to the future performance of the ARR, uncertainty as to if and when term rates will be developed for an ARR, and possible discrepancies in approaches to calculating the compounded ARR over the interest period; and
- possible tax, accounting, or regulatory impact: moving from the relevant interest rate benchmark to a fallback or replacement rate may raise a variety of tax, accounting, and regulatory risks such that the product or service no longer meets the purpose you originally intended it to serve or is no longer compatible with the discounting rates or systems that you currently operate.
Wells Fargo cannot provide any assurances as to the consequences, or likely costs or expenses associated with any of the changes arising from the LIBOR transition, though they may be important to you. The above is provided for informational purposes only and is not intended to apply to any specific customer or transaction.
Wells Fargo Investment Institute, Inc. (WFII) is a registered investment adviser and wholly-owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.