Preparing your business for the LIBOR transition
Understand why LIBOR is coming to an end.
September 16, 2021 6 min read
A worldwide transition away from the London Interbank Offered Rate (LIBOR) to alternative rates has begun. The global transition is not restricted to the financial industry and could affect any business that relies on access to capital and debt instruments. Preparation is the key to a smooth transition.
LIBOR is a benchmark for interest rate calculations in financial contracts. Over time, the declining volume of underlying financial transactions has increased the reliance on judgment from a panel of banks rather than on robust market data. This has impacted LIBOR’s credibility, which is why LIBOR is being phased out over a number of years.
How do businesses use LIBOR?
Lenders and other financial institutions use LIBOR to set interest rates on various loan products and hedge financial exposure using LIBOR-based derivatives. As a benchmark rate, LIBOR also affects credit cards, student loans, corporate loans and mortgages.
Using it as a common benchmark, many debt instruments incorporate LIBOR into their contract language. For example, a contract might stipulate a floating interest rate as LIBOR plus 200 basis points to be paid quarterly. Benchmark rates are especially important in derivatives trading and interest rate swaps, allowing corporations to manage their borrowing costs and interest rate risk.
What is the impact of the LIBOR phase out?
USD LIBOR will be fully phased out by June 30, 2023. The leading replacement rate contender in the U.S. is the Secured Overnight Financing Rate (SOFR), which is recommended by the Alternative Reference Rates Committee (ARRC), an industry body convened by the Federal Reserve Board and the Federal Reserve Bank of New York. However, there are other alternative rates being considered in the market, including the Bloomberg Short-Term Bank Yield Index (BSBY) and Ameribor. SOFR is based on far more extensive underlying transactions than is LIBOR, and all three rates are constructed to be more robust than LIBOR.
Approximately $200 trillion in debt and contracts needs to be transitioned away from LIBOR by the end of June 2023. The complexity of this process can’t be emphasized enough when you consider the widespread use of LIBOR across national and international financial products. While derivatives and commercial lending markets will be widely impacted by the LIBOR transition, consumer credit products such as private student loans, adjustable-rate mortgages and other debt instruments will also be affected.
As part of the transition, new LIBOR products will no longer be originated after December 2021, as regulators have stated that LIBOR originations after this point will pose a safety and soundness risk for banks. This clearly defines the transition period. Starting now, we are phasing out new LIBOR originations. By June 30, 2023, when LIBOR will no longer be published, we will have transitioned all LIBOR exposures to alternative rates. The process is already underway with the widespread inclusion of hardwired fallback language across the industry. This may provide added pressure and incentive for businesses to react quickly in order to begin the transition process.
- Dec. 31, 2021—No new LIBOR originations after this point; non-USD LIBOR tenors and 1 Week and 2 Month USD LIBOR tenors no longer published.
- June 30, 2023—Cessation of O/N, 1M, 3M, 6M and 12M USD LIBOR tenors; hardwired fallback triggered to convert remaining LIBOR contracts to alternative rates.
Is your business prepared for the LIBOR transition?
To begin the transition, identify your company’s outstanding LIBOR-based obligations. Any USD LIBOR agreements (excluding 1 Week and 2 Month tenors) that mature before June 30, 2023, require no action. For LIBOR-based obligations that remain in force after that date, there are three transition methods you may use:
- Refinance to an alternative rate—Close the LIBOR contract and originate a new credit agreement based on SOFR.
- Insert hardwired fallback language—Clearly define the transition path from LIBOR to SOFR, to be triggered after USD LIBOR cessation on June 30, 2023.
- Add a direct-to-SOFR amendment—Draft an agreement to transition to SOFR effective at the beginning of the next accrual period.
According to ARRC recommendations, the transition from LIBOR to SOFR requires the addition of a five-year median spread adjustment published by Bloomberg to roughly equate SOFR to LIBOR. This adjustment must be included in the hardwired fallback language.
If you choose to refinance your debt, it would involve re-underwriting and new pricing. Amending your current contract or inserting new language would allow you to maintain the current underwriting and switch the base interest rate from LIBOR to SOFR or other rates.
How Capital One can help your business transition from LIBOR
At Capital One, we’re committed to making the LIBOR transition as smooth as possible for our clients. Our team is actively participating in industry forums and incorporating published recommendations into our transition approach where appropriate. We’re also adjusting our systems and training our associates to provide our clients industry-leading expertise.
We’re here to ease the impact the transition away from LIBOR might have on you and your business. Start planning and preparing by contacting your Capital One relationship manager today.