Lenders, LIBOR, and the move to the risk-free SOFR rate: seven takeaways for financial services firms
Business lenders and the coming LIBOR transition
Around the financial industry, executives are preparing for the end of LIBOR: the London Interbank Offered Rate. The most widely used tenors of USD LIBOR are expected to cease publication after June 2023**, and firms have been making progress in preparing to remediate derivative contracts, consumer loans, and other products tied to the widely used interest rate benchmark.
Meanwhile, business lenders have been surprisingly slow to get on board. This is arguably the slowest part of the transition away from LIBOR, even as the clock is ticking. For some time now, the Alternative Reference Rates Committee (ARRC) has suggested that business lenders should be incorporating “hardwired fallbacks” into their syndicated loan contracts and bilateral loans. These fallbacks would specify an alternative reference rate to automatically replace LIBOR if it were no longer being published for any reason. The ARRC is encouraging lenders to stop using USD LIBOR for any new business loans after June 30, 2021. And US regulators have recently issued guidance suggesting that firms should stop issuing new USD LIBOR products as soon as practicable, but in any event by December 31, 2021.
**For years, the industry has been working toward a 2021 transition away from LIBOR. But the benchmark’s administrator, ICE Benchmark Administration (IBA), recently announced that it would continue to publish some LIBOR rates — but not all — for an additional 18 months. See PwC’s LIBOR transition industry and market update for late November 2020 for more details.
Understanding the challenge
To be fair, the transition away from LIBOR could be challenging, since the ARRC’s recommended alternative reference rate (ARR) — the Secured Overnight Financing Rate (SOFR) — differs from LIBOR in some key ways.
LIBOR vs. SOFR
- As its name indicates, SOFR is an overnight rate. LIBOR is a forward looking benchmark, with terms ranging from overnight to twelve months. Market participants have gotten used to the term rate structure, and many have been clamoring for a term rate structure for SOFR. While one may develop, regulators have repeatedly cautioned against waiting for one.
- Since SOFR is collateralized by Treasuries, it is considered a risk-free rate (RFR), without any credit premium built in. This could potentially create misalignments with lenders’ own risks: for example, during a credit crunch, SOFR might contract, reducing interest earnings just when lenders’ own funding costs may increase.
Operational issues. Financial institutions will have to adjust their own operational systems, and they’ll need to make sure their vendors have upgraded too. To switch benchmarks, companies will need to handle compounded and/or simple average calculations, shifts, lookbacks, and other convention components.
Client concerns. The industry has been anticipating this switch for years, long before the pandemic hit. Now, as lenders will need to reach out to their borrowers, they may find that many are struggling with the broader macroeconomic environment. Any move by a lender to renegotiate a contract, even to address an industry-wide issue, may be seen skeptically.
Lack of clarity. Both borrowers and lenders may rightly point out that there is no clearly defined convention that spells out how to calculate interest once LIBOR has been replaced by SOFR. With LIBOR, a borrower knows in advance what they owe because the rate is specified at the beginning of the term. As a backward-looking rate, SOFR is being calculated through a given time period, up to the point that payment is due. There are different approaches that might address this, such as a “lockout” (fixing the rate a few days before the end of the period) or a “lookback” (calculating interest over the same number of days, but shifting the start and end dates backward a few days.
While lenders may not like the idea of abandoning LIBOR, regulators in the US and around the world have made clear that its days are numbered. Fortunately, with new pricing and funding strategies, a careful approach to client relations, advance work on operational readiness, and steps to align new SOFR loans and legacy LIBOR loans, the transition can be both smooth and profitable for your company.
What this means for your business: seven key takeaways
The LIBOR-to-SOFR transition will ripple throughout the global economy in the coming months, and nearly every financial institution could need to make operational changes to be ready. And, upgrading systems may not be enough. Financial institutions will also need a strategy to ensure that they can navigate the new world of risk-free rate lending. Here are seven takeaways to guide that strategy:
- Don’t count on a SOFR alternative
- Adapt pricing strategies for risk-free rate lending
- Manage the risks to your balance sheet
- Talk to your clients — carefully
- Prepare for multiple SOFR conventions
- Work with vendors — and be ready with tactical solutions
- Keep going
Keep going
It should be clear that there is a lot to do in a short amount of time. By now, you are likely well underway with a transition plan, and recent announcements about the final termination date should encourage you to accelerate your work. If you haven’t done much yet, the more you are able to model your potential approaches, the more likely you are to see favorable results. You’ll want to start the process now to analyze contracts and work with counterparties so that when any of your legacy LIBOR loans are transitioned to SOFR, they’ll be priced and booked appropriately.
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John Oliver
Partner, Governance Insights Center & National FinTech Trust Services Co-Leader, PwC US
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