LIBOR Reform

Implications of the Changes to the LIBOR Rate on the Existing Loan Market

Following the financial crisis of 2007 and 2008 significant reforms were called for in the London Interbank Offered Rate (ICE LIBOR or “LIBOR”). These reforms were spurred by three issues: regulator’s fears over having a single rate with no credible alternative or back-up rates; allegedly inaccurate or manipulated individual panel bank submissions scandals; and the implication that senior United Kingdom regulators asked banks to alter their reporting to project financial strength. These proved to be more than the United Kingdom could stand, and thus Libor was transferred from the control of the bank market association to a regulated independent operator. This change opened the door to two major challenges: other rates that are proposed to supplant traditional LIBOR and how to deal with those changes in LIBOR regulation, especially in the context of extant loans.

For United States lenders there are two main choices going forward. U.S. banks can either elect to stay with the reformed LIBOR rate operator, or switch to the U.S. organized Secured Overnight Funding Rate (“SOFR”). The SOFR is a rate that is a secured overnight Treasuries repo rate (i.e., the interest rate paid on overnight loans collateralized by US government debt; collateral that is high-quality, liquid, and accepted as collateral by the majority of intermediaries in the repo market). One of the most glaring omissions in the calculation of the SOFR is that, unlike LIBOR, it does not take into account bank credit risk, thus the resulting rate is frequently significantly lower than the corresponding LIBOR rate for the same period. The New York Fed anticipates publishing this rate beginning April 3, 2018.

The greatest complications of any of the new rate is in how it affects outstanding loans and obligation of lending institutions that are already pegged to the LIBOR rate.

If the LIBOR reforms prove adequate and are widely accepted by the market, then there are should be no necessary changes to existing contracts. The main issue for banks would be in ensuring that they insert some language into new credit agreements to adequately address specifically that they will be applying the LIBOR rate as its calculation methodology may change from time to time.

If the LIBOR reforms are deemed inadequate by the market and backup or replacement rates become relevant, then there are a number of issues that arise and must be addressed. The largest and most glaring issue is how to address contracts that do not adequately provide for a transition to a rate other than LIBOR. These can be addressed in four main ways:

  • Option 1: An overriding law is passed, which statutorily forces conversion. The main risk to this option is that not all jurisdictions possess the legislative power to implement this option.
  • Option 2: Parties agree to amend the existing contract to provide for transition to the new rates. The main risk with this option that the SOFR is new and will likely require fine-tuning to address any kinks in the calculation of a fair and representative rate, thus any amendment will likely need to involve flexibility for the change rate without the need for amendment every time.
  • Option 3: Just wait for maturity. Lenders could just wait until obligations mature and thus rely on the changes of the reformed LIBOR rate. This option will likely be adequate for short term contracts, but will become increasingly problematic and risky with contracts that extend beyond the transition date.
  • Option 4: Refinancing. The Lenders could always refinance debt instruments that are subject to LIBOR thus bringing them into immediate compliance. The risks associated with this method are in the fees and costs associated with such refinancing (i.e., for Borrowers, the refinanced debt may be more expensive than their existing debt, may give rise to prepayment penalties, or may trigger debt modification regulations)

Regardless of how the market addresses the changing interest rates the change itself can be detrimental to banks portfolios of existing credit obligations. To combat this, banks will need to be proactive in identifying outstanding credit instruments which will be affected by the changes in LIBOR and how they internally wish to address each outstanding credit individually.