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Fundamental change is coming to the floating rate loan market. After more than 40 years, the London Interbank Offered Rate or LIBOR – the benchmark index by which major global banks lend to one another – is being phased out by the end of 2021. The index primed to replace it, the Secured Overnight Financing Rate or SOFR, is more reliable and secure. The transition has implications for lenders, borrowers, regulation, legality and accounting, for both existing contracts and new ones. The good news: preparation has been long underway to ease the change.

From LIBOR to SOFR: Understanding and Easing the Index Rate Transition in Lending

Experts from KeyBank, Jones Day and Ernst & Young held a discussion about the LIBOR wind-down, why it is happening and what clients should expect over the next year.

Participants were:

  • Anthony Bulic, Senior Vice President, Securitization, Hedging & Analytics, KeyBank
  • Jason Jurgens, Partner, Jones Day, Financial Markets Practice
  • Jeff Vitali, Partner, Ernst & Young, Financial Services Practice
  • Doug Dell, Middle Market Commercial Sales Lead, KeyBank

The Why and When of the LIBOR Transition

LIBOR was established as the benchmark index when the interbank lending market was very active. However, in response to a regulatory environment that required banks to hold more liquidity, the volume of unsecured bank debt market activity slowed considerably. LIBOR was calculated by submitted estimates from panel banks. Bulic explained that as LIBOR became more estimate-based and subjective, it was more susceptible to manipulation, which occurred during the financial crisis.

With LIBOR no longer a reliable benchmark, the United Kingdom-based Financial Conduct Authority (FCA), which oversees the rate, announced it will cease compelling banks to continue to submit rates beyond 2021. Bulic notes that although the financial industry is working toward a transition date of December 31, 2021, the FCA has indicated that if LIBOR becomes unrepresentative early, it reserves the right to end earlier. Most experts believe that the lending industry will stop closing LIBOR loans sometime between July and September of 2021.

LIBOR’s Expected Successor: SOFR

With the floating rate loan market not going away, the financial community was in need of a move from LIBOR to a more transparent and robust rate. In anticipation, the Alternative Reference Rate Committee (ARRC) was convened by the U.S. Federal Reserve, comprising stakeholders including banks, accounting firms, legal firms, technology firms and loan servicing firms. The ARRC and the International Swaps and Derivatives Association (ISDA) set the criteria for the replacement benchmark – a deep market and transparent rate calculation. Bulic notes that a deep market was key to prevent manipulation.

The selected replacement benchmark, SOFR, represents the rate at which a borrower can borrow funding overnight secured by treasuries. SOFR is used for trillions of dollars of deals each day, representing a vast breadth of transactions, so it “ticks the box” of being a deep market, according to Bulic. Each day, the Fed publishes the SOFR rate from the night before and also publishes a variety of averages over time ranges, making it transparent as well.

LIBOR and SOFR are different in two primary ways that will impact how the lending industry will structure deals. First, LIBOR is based on submissions from the panel banks and because of that human intervention, is very smooth. SOFR, on the other hand, is backward-looking and based on actual transactions so it can be choppy. Second, LIBOR is unsecured, so it has a credit risk component. Conversely, SOFR is risk-free because it’s secured. Those differences mean that on average SOFR is lower than LIBOR.

In addition, because LIBOR has been around a long time, it has a term structure, but because SOFR is an overnight rate, it does not have a term rate. Bulic says lenders believe a term rate for SOFR will develop over time.

Because LIBOR moves in anticipation of the Fed acting, while SOFR moves in response to the actual, it is easy to see how SOFR and LIBOR diverge when a significant macroeconomic stress – such as the COVID-19 pandemic – hits the market.

What Are the Regulatory and Legal Ramifications?

The scope of the LIBOR transition means regulatory bodies at every level will be involved. Jurgens outlined the legal landscape that will guide the process. The FCA, which regulates LIBOR, will continue to set the timing, he says. In the U.S., loans, whether bilateral loans or syndicated loans, are governed by state law and state regulators focused on banking, consumer issues and small business. On the federal level, while there is only one law that actually references LIBOR specifically, many regulatory bodies are involved in the banking industry, and other regulations, such as the tax code, need to be considered in loan contracts.

Jurgens says that when the FCA’s Chief Executive Andrew Bailey first announced that LIBOR would cease, it rattled the market and many believed it wouldn’t come to pass. However, by 2018, acceptance had set in and by 2019, the ARRC and ISDA published guidelines on new bilateral and syndicated loans.

However, financial organizations still had to contend with legacy deals in a variety of product types, including commercial loans and interest rate swaps, consumer products such as student loans and mortgages, and securitizations and complex structured financial arrangements like mortgage-backed securities and collateralized debt organizations. A wide variety of product types are impacted by LIBOR going away, and each has their own set of legal issues and risks. The question became, “What do you do to address these legacy deals?”

The ARRC proposed legislation, focused on contracts governed by New York state law. The proposal outlined that for transactions with no fallbacks or unworkable fallbacks, the contract would change by operation of law to the ARRC recommended rate, which would likely be some form of SOFR. Second, for transactions that provide a party with some discretion to select a new rate, there's a safe harbor against potential litigation claims if you use the ARRC recommended rate. And third, parties have the ability to opt out of the recommended rate through a bilateral amendment. The ARRC assumed that if New York State adopts the law, other states will follow suit along similar lines. At the same time, drafted federal bills are attempting to address the same issues.

However, political uncertainty about reaching an agreement and constitutional questions about how legislation delegates responsibility mean that a legislative solution is not likely. Jurgens instead says contract amendments will be needed to eliminate legal and pricing risk.

“We don’t foresee litigation in the commercial lending space, instead we see banks undertaking amendment campaigns to address uncertainties,” he said. The contracts need to be amended because when they were entered, some didn’t have any fallback provisions or temporary fallback measures because no one anticipated LIBOR going away permanently.

In looking at new deals, the move from LIBOR to SOFR will bring changes in how we do business, and those changes can bring risk. Switching to SOFR will inevitably impact financing arrangements, but it may also impact cash flows, vendor agreements, employment or consultant contracts, and pending acquisitions. Jurgens urges companies to consider how using a backward-looking rate such as SOFR changes how you assess cash management. For companies that may hedge, SOFR will impact their hedging strategy. And to prevent operation risks, companies should update financial systems or models that use LIBOR.

What Are the Accounting Implications?

The extensive contract modifications that need to be completed carry with them significant implications for accounting. Vitali explained that the current accounting model would require an analysis of loan amendments through various accounting tests, such as the troubled debt restructuring test, fair value measurement, impairment input, interest income calculation, compensation and benefits and hedge accounting.

For example, Vitali pointed to fair value measure. As the transition accelerates next year to where SOFR volumes are increasing and LIBOR liquidity and LIBOR volumes are decreasing, there could be an inflection point where legacy LIBOR-based instruments are now no longer being quoted in as active and liquid a market as they are today, so they may not qualify as a level-one financial instrument. So within the fair value hierarchy of evaluation, there could be some impacts related to this transition from LIBOR to SOFR.

However, the Financial Account Standards Board has issued some relief guidance that if certain gating criteria are met, the accounting tests for contract modifications do not have to be done. Vitali notes that in essence, the gating criteria established that if modifications are being made to contracts that are solely related to LIBOR reference rate reform, then you can account for any impact or any change on a prospective basis.

What You Can Expect from KeyBank During the Transition

As complex as the LIBOR transition is for the lending industry, borrowers should take heed that financial institutions are preparing to make it as smooth as possible for them. Dell says that KeyBank is evaluating more than 20,000 contracts and 3,500 swap contracts, with client communication and transparency at the forefront, particularly when it comes to changes that could impact your interest cost and billings.

KeyBank is ready to originate SOFR-based loans beginning in the fourth quarter of 2020. Borrowers who decide to renew their LIBOR-based loan with a SOFR rate will not need to go through the amendment process. Any remaining LIBOR-based loans that mature after December 2021 will need to be amended with a SOFR rate. To make the process more efficient, KeyBank has developed artificial intelligence tools to identify loans that need to be amended and produce appropriate amendment documents. This process will begin in the first half of 2021 with outreach from your KeyBank relationship manager. For clients of the income property group or Community Development Lending and Investment group, the process will be a more hands-on legal review rather than automated.

For determining a SOFR-based interest rate, clients should expect two separate paths: one for LIBOR loans that will be amended with a SOFR rate, and another for new loans originated with the SOFR rate.

  • For existing loans, an index spread adjustment will be added to the SOFR index to make the right more consistent with LIBOR. Your loan margin, or your spread over the adjusted index, will remain the same as if it was for your previous LIBOR loan. That index spread adjustment will be determined on the cessation date of LIBOR based on the five-year average of the difference between LIBOR and SOFR. That adjustment will not change over the remaining life of the loan.
  • For new loans that use a SOFR index, there will be no adjustment factor. Instead, the spread or margin over the adjusted SOFR index, which is typically lower than LIBOR, will be adjusted somewhat higher to recognize the risk differential between LIBOR and SOFR. The interest rate equation is the SOFR index plus the new spread over SOFR.

For billing, since SOFR is a backward-looking rate, the bank will use what is called a look-back method, which applies the daily rate in arrears for a set period before the current day’s balance. This will allow for timely billing and payment on a set schedule.

Conclusion

The move from LIBOR to a stronger, secure and more reliable rate has been a long time coming, but it will require a coordinated effort to amend legacy LIBOR-based contracts and begin closing new SOFR-based deals throughout 2021. The lending industry and legal and accounting firms that service it are all focused on making the transition as turnkey as possible for clients, and regulatory and oversight agencies are guiding the way.

For more information on how the LIBOR transition impacts your business, please contact your KeyBank relationship manager.