The UK’s Financial Conduct Authority (FCA) has made it clear that the publication of LIBOR, the London Interbank Offered Rate, will cease. LIBOR, a benchmark interest rate at which major global banks lend to one another in the interbank market, is underpinning over $200 trillion USD of financial contracts. With the approaching end to LIBOR as an interest rate index, financial institutions and individuals or entities with loans that could be impacted need to understand what this change means in order to limit disruption and mitigate risk.
On March 5, 2021, the ICE Benchmark Administration, the benchmark administrator for LIBOR (IBA), and the UK Financial Conduct Authority, the regulatory supervisor of the IBA (FCA), announced the dates after which all 35 LIBOR settings will either cease to be provided or will no longer be representative. This confirmation followed a similar November 30 statement by the Federal Reserve Board around the proposed cessation dates and provides certainty regarding when LIBOR rates will no longer be available.
Following this announcement, the fallback spread adjustments were published and set by Bloomberg, effective March 5, 2021.This did not trigger implementation of a new reference rate for existing loans or swaps.
The Federal Reserve Board, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency previously issued guidance encouraging banks to stop entering new USD LIBOR contracts as soon as practicable, but no later than December 31, 2021. Further, regulators have directed banks that any new lending or derivatives contracts entered into during 2021 should utilize an alternative index rate or include fallback language that clearly defines an alternative index rate following the discontinuing of LIBOR. PNC has the ability to issue new loans and swaps using rates other than LIBOR.
LIBOR has been used globally as a benchmark to gauge funding costs and investment returns for financial contracts for more than 3 decades. It is used to help set the interest rates on many loans, swaps, bonds, credit cards, adjustable rate mortgages, and other products offered by financial institutions.
Changing industry norms and LIBOR manipulation scandals are driving a shift away from LIBOR, causing interbank lending markets to become much thinner and the number of actual transactions upon which the rate is based to decrease significantly. That has caused regulators globally to actively advocate that markets move away from LIBOR to a more reliable index.
PNC has a large team dedicated to this transition that is active in many industry working groups and closely engaged with market activities. PNC will provide further updates and new documents or amendments to existing documents to facilitate the transition as replacement reference rates are identified and implemented in the financial industry generally.
Due to regulatory guidance, PNC cannot originate new LIBOR loans after December 31, 2021. PNC began limiting new LIBOR loan originations starting in September 2021.
Neither the industry nor PNC has found a perfect replacement for LIBOR, though market participants have developed various rate alternatives, including the Secured Overnight Financing Rate (SOFR) and Bloomberg’s Short-Term Bank Yield Index (BSBY).
The Alternative Reference Rates Committee (ARRC), an industry group convened by the Federal Reserve Board and the New York Fed, recommends using the Secured Overnight Financing Rate (SOFR). SOFR is considered a more robust reference rate than LIBOR as it is wholly based on actual transactions and represents an active daily market (over $750B in transactions).
Bloomberg has developed a credit sensitive Short-Term Bank Yield Index (BSBY) based on transaction related data, including both actual executed transactions and firm executable quotes (over $150B in transactions). Commercial lending participants have started to adopt BSBY given it has characteristics more similar to LIBOR.
Although LIBOR and SOFR reflect short-term borrowing costs and are available in multiple tenors, they are calculated very differently:
BSBY was constructed to be different from LIBOR and designed to meet a market need:
Loan documentation generally provides that if LIBOR is no longer available, the interest rate will be based on the Prime Rate.
Due to the anticipated discontinuation of LIBOR, loans originated or modified in the past couple of years have included fallback language outlining a detailed mechanism to amend the loan documents to incorporate a new reference rate to replace LIBOR, as well as a spread and other adjustments to account for differences between LIBOR and the new reference rate.
If a client seeks an amendment to an existing LIBOR-based loan after December 31, 2021 that extends the tenor, increases the size or amends the pricing, that amendment will be required to implement a rate other than LIBOR.
PNC has the ability to issue new loans using rates other than LIBOR.
Regardless of the loan index that clients choose, PNC has a swap product that is available to align the swap to the index of the client’s loan. In concert with C&IB’s lending strategy, PNC now also has the capability to transact swaps using BSBY and SOFR.
Related to swap fallbacks: Swap documentation historically has not provided for a fallback rate if LIBOR were to be permanently discontinued. In January 2021, the International Swaps and Derivatives Association (ISDA) finalized an update to its derivatives definitions to include LIBOR cessation fallback provisions. These updates name the LIBOR replacement rate as SOFR (compounded in arrears) plus a spread adjustment based on the 5-year median spot difference between USD LIBOR and SOFR. The updated definitions were published and are effective for any new or amended LIBOR swap contracts executed on or after January 25, 2021.
However, clients have options to choose other fallbacks to preserve maximum symmetry between a loan and associated swap. PNC loans entered into or amended after November 2020 generally include hardwired replacement provisions that are consistent with those recommended by ARRC (the committee convened by the Federal Reserve Board to focus on LIBOR transition).
Related to legacy swaps without adequate fallbacks: For existing swap contracts maturing beyond June 2023, PNC will begin to contact clients starting in 2022 to amend and incorporate adequate fallback language and replacement provisions.
PNC expects a multi-rate environment to exist following LIBOR cessation. Contracts that have already been updated to include the ‘hardwired approach’ will continue to use SOFR as the replacement rate. Going forward, PNC plans to prioritize offering BSBY in new contracts, however PNC can support other replacement rates. Other rate alternatives will continue to be evaluated as the market develops.
For foreign currency IBOR rates, PNC expects to transition to the industry recommended risk-free-rates of SARON (CHF), ESTR (EUR), SONIA (GBP) and TONAR (JPY) by the end of 2021, as required.
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