LIBOR Transition FAQs
1. What is LIBOR?
The London Interbank Offered Rate (LIBOR) is a benchmark variable interest rate which major global banks use to lend to one another, published daily by the Intercontinental Exchange Benchmark Administration (ICE). LIBOR is the dominant benchmark rate for determining interest payments on variable rate financial products. There are trillions of dollars of loan and derivatives contracts tied to LIBOR.
The methodology for calculating LIBOR has remained largely unchanged since it was introduced. Each day, a group of large banks, known as “panel banks,” report their funding rates to ICE, which averages, adjusts, and publishes those rates on a daily basis.
2. What is the LIBOR transition?
The “LIBOR transition” references the discontinuation of LIBOR and the transition of financial products away from LIBOR-based rates.
3. Why is the LIBOR transition happening?
There are two main concerns with the LIBOR calculation process:
- First, there has been a significant decline in the sample size for calculating LIBOR since the 2008 financial crisis. Fewer panel banks have been reporting, and those that do report fewer quotes based on market transactions. Instead, LIBOR has increasingly relied on what ICE calls "market and transaction data-based expert judgment." Therefore, concerns were raised about how well LIBOR reflects market realities since it is not based on actual market transactions.
- Second, LIBOR’s reliance on inputs from panel banks opened it to manipulation, and there have been a range of irregularities uncovered by regulators, which have led to large fines for those involved.
As a result, global regulatory initiatives have sought to develop alternative reference rates and to discontinue the use of LIBOR.
4. When will LIBOR rates no longer be available?
ICE has confirmed that most tenors of U.S. Dollar LIBOR (including one-month LIBOR, the tenor most frequently used for business loans) will not be published on a representative basis after June 30, 2023. One-week and two-month LIBOR will not be published after December 31, 2021. Federal banking regulators have instructed banks to stop originating new LIBOR loans no later than December 31, 2021.
5. Are regulators mandating a specific replacement for LIBOR?
No. Federal bank regulators have issued a joint statement stating that the regulators do not intend to recommend a specific rate for use in place of LIBOR. The agencies recommended that financial institutions “use any reference rate for its loans that the bank determines to be appropriate for its funding model and customer needs.” Different financial institutions may conclude that different alternative rates may be better or worse for their particular institutions, and replacement rates could also vary by product type.
6. What are possible replacement rates for LIBOR?
Many different rates have been considered as replacement indexes by different institutions and we are closely watching the market to monitor market acceptance. Potential replacement and alternative rates include Wall Street Journal Prime, SOFR, and BSBY.
7. What is SOFR?
The Secured Overnight Financing Rate (SOFR) represents the interest rate that banks impose on each other in making loans secured by U.S. treasuries. SOFR is a daily, overnight, secured, risk-free rate, released by the Fed every morning. SOFR may include:
“Daily Simple SOFR” or “Average SOFR in Arrears” is a “lookback” rate based on daily SOFR rates that have occurred prior to the relevant interest accrual period, and can include an average of the daily SOFR rate for each day over the preceding period (for example, one month).
“Term SOFR” is a forward-looking rate representing a projection of what daily SOFR will be on a certain date in the future.
Unlike LIBOR, which is a forward-looking, credit-sensitive rate meant to represent a bank’s cost of capital, SOFR measures rates applicable to short-term, secured financing. Because SOFR is secured and risk-free, while LIBOR is unsecured, SOFR has historically been (and can be expected to be) a lower rate than LIBOR, and will require a spread adjustment if used as a replacement to a LIBOR-based loan.
The Alternative Reference Rates Committee (ARRC), a group convened by the Federal Reserve Bank of New York, has recommended SOFR as a LIBOR alternative.
8. What is BSBY?
The Bloomberg Short-Term Bank Yield Index (BSBY) is a proprietary, credit-sensitive index that incorporates bank credit spreads and defines a forward term structure. BSBY seeks to measure the average yields at which large global banks access USD senior unsecured marginal wholesale funding. The index is based on aggregated anonymized data anchored in transactions and executable quotes sourced from Bloomberg’s electronic trading solutions and trades of short-term senior unsecured bank corporate bonds reported by FINRA.
Despite ARRC’s recommendation of SOFR as the primary replacement of/alternative to LIBOR, BSBY has been gaining market acceptance, particularly because of its nature as a credit-sensitive, forward-looking term rate that has historically behaved very similarly to LIBOR. BSBY has a 99.6% correlation with 1m USD LIBOR, and tends to run only 2-4 bps less than LIBOR.
Comparison of BSBY v. LIBOR
- Both reflect market lending costs
- As forward-looking rates, both anticipate policy rate moves
- In a 3-year back-test, BSBY has a 99.6% correlation with LIBOR
Comparison of BSBY v. SOFR
- Both are based on significant transactional volume
- Neither is reliant on expert judgment
- As a forward-looking term rate, both BSBY and Term SOFR endeavor to anticipate policy rate moves in advance. As an overnight rate, Daily Simple SOFR or Average SOFR in Arrears reflect rate moves after the fact.
- SOFR is based on repo transactions, and will respond to liquidity changes in that market. BSBY will respond to conditions in financial markets which affect pricing of short-term funding sources.
9. Which of these replacement rates will First Commonwealth be using?
We are carefully watching the market in order to make our final decision on replacement rates to use for existing LIBOR-based loans that will need to be transitioned in 2023. We are testing systems capability and developing language for a variety of alternatives so we can be prepared to quickly implement new rates when appropriate.
10. What happens to my existing LIBOR-based loan?
LIBOR-based loans that mature after June 30, 2023 will need to be transitioned to an alternative fallback rate, which we are still determining. We have been working to ensure appropriate fallback language is included in all loan documents to give us the ability to designate a replacement rate and make any necessary adjustments to the spread/margin and calculation methodology in order to make the transition as economically neutral as practicable, to be fair for both our borrowers and the bank.
11. What about LIBOR-based loans that are subject to a Swap, hedge, or other rate management derivative product?
Swaps and other derivative products define the index rate used separately from the underlying loan documents, and those currently referencing a LIBOR index will also need to be revised to use an alternate index rate when LIBOR becomes unavailable. For the derivatives products to function as intended to manage interest rate risk, the replacement index in the derivatives product should match the replacement index used in the underlying loan transaction. This will require that we execute bilateral amendments to derivatives documents with our borrower counterparties. While we are still monitoring the market and making final determinations, it is likely that existing LIBOR-based derivatives (and their related loans) will be transitioned either to a BSBY or Term SOFR index. This transition will need to occur prior to June 30, 2023.
12. Will the LIBOR transition affect loans that are priced at an ICE Swap Rate?
Yes. For some loan transactions that use long-term (multi-year) repricing mechanisms, we utilize the ICE Swap Rate, which is based upon underlying LIBOR-rate derivatives transactions, and thus indirectly linked to LIBOR. ICE has noted that there can be no certainty or guarantee that these ICE Swap Rates will be published after publication of LIBOR is discontinued. It is unclear at this point whether the effects of the LIBOR phase-out on Swap Rates will emerge following the initial 12/31/21 transition date (after which one week and two month LIOBR will cease to be published), the 6/30/23 transition date (on which all other US Dollar LIBOR tenors will cease to be published), or sometime in between. There is a strong possibility that an ICE Swap Rate may emerge that is based on underlying SOFR-based transactions, rather than LIBOR-based transactions, which (subject to appropriate adjustments) could be used as a replacement. The LIBOR transition would only affect Swap Rate loans that are subject to repricing after the relevant transition date; loans that were fixed based on a Swap Rate as of an earlier date of determination would not be affected. Letters have been sent to clients with loans set to reprice based on a Swap Index on or after January 1, 2022 in order to incorporate more robust fallback language.