The London Interbank Offer Rate (LIBOR) is the basis index for a large number of financial instruments from interest rate swaps to adjustable rate mortgages. In 2008, an investigation exposed a LIBOR rate manipulation scandal leading to an erosion of trust in the index. LIBOR is expected to be phased out of use by late 2021.
As banks begin to move away from LIBOR they will need to review their risk profiles as well as any instruments using LIBOR to begin the transition to a new index.
Institutions must first assess their exposure for on- and off-balance sheet items subject to LIBOR. Senior management should oversee the risk assessment, and regular updates should be provided to the board of directors. As part of the initial review to identify LIBOR exposure the bank should take the opportunity to check financial instruments for any fallback language designating a substitute index and any required triggering events for the change. If fallback language is not included, banks may need to rely on currently proposed regulatory changes when LIBOR becomes unavailable or unreliable.
For customers facing exposure the Consumer Financial Protection Bureau recently published a proposed update to Regulation Z to deal with the impending transition away from LIBOR. The proposed regulation identifies both the Prime Rate and the Secure Overnight Funding Rate (SOFR) as proposed replacements for LIBOR for the purposes of the Truth in Lending regulation. The proposed regulation sets out a time frame for the transition to provide a safe harbor for the transition in certain consumer situations. The CFPB also published a FAQ which can be found here.
Transitioning away from LIBOR may also affect third-party service providers used by banks to process loans, provide modeling, prepare documents, or any number of other services.
Banks should coordinate with any third-party service providers and vendors to ensure they are capable of transitioning away from LIBOR on the bank’s timetable.
Given the multifaceted risks involved with the LIBOR transition, it is unsurprising that banking regulators will likely concentrate on transition issues during upcoming exams. The Federal Financial Institutions Examination Council (FFIEC) issued a statement on July 1, 2020 outlining issues likely to be discussed during upcoming exams including:
- Identification and quantification of LIBOR exposure
- Risk assessment of LIBOR exposures including scenario testing and legal review
- Transition plans with included milestones and key completion dates
- Management’s assessment of revisions that may be necessary to update policies, processes, and internal controls
- Responsibility for LIBOR transition oversight
- Process for reporting to senior managers and the board of directors on the LIBOR transition plan
Banks who have not yet started their LIBOR exposure reviews should begin their review in the next few weeks.
Banks needing assistance in developing a plan to assess exposure risk, preparing a transition plan, or reviewing their policies should contact their attorney to assist in meeting both the financial and regulatory needs of the transition.