How the End of LIBOR Affects Banks, Borrowers & Investors

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The London Interbank Offered Rate (LIBOR) has been central to the global financial system since the 1980s. It persisted even despite nearly a decade’s worth of calls for a new benchmark interest rate after the 2012 rate-rigging scandal.

Now, LIBOR’s demise is finally (really) almost here. In a September 2019 speech, John C. Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, called the end of LIBOR one of three guarantees in life alongside death and taxes. He said he couldn’t “emphasize enough that the clock is ticking and everyone needs to get their firms ready for January 1, 2022.” He also warned that banks’ growing reluctance to provide LIBOR submissions is already adding further risk to using the rate.

The Secured Overnight Financing Rate (SOFR), LIBOR’s replacement, differs in ways that mitigate that risk. Unlike LIBOR, which is based on recent-day submissions of unsecured transaction data, SOFR is based on secured lending rates from the repo markets looking back 30 days.

SOFR has traditionally only been used as a benchmark for short-term loan issuance, but a few leading institutions are beginning to use it in new instruments with 5-or-more-year loan terms. SOFR’s success as a broadly used benchmark depends on more banks having the tools and capability to do the same, which should soon be in place. (The New York Fed is preparing average SOFR rates and a SOFR index, with the goal of publishing them daily by the middle of 2020.)

In the meantime, the implementation of SOFR and phaseout of LIBOR is creating changes that affect many constituents across the financial markets. Here’s a primer on what banks, borrowers, and investors are working through on their way to a post-LIBOR landscape.

How It Impacts Banks

Financial institutions are facing a complex change with the LIBOR transition—one requiring scrutiny and adaptation of every LIBOR-denominated debt instrument they have under contract or available to customers. The rate is used in an estimated $350 trillion of loans, securities, and derivatives worldwide.

Reviewing and updating that much financial material is an immense challenge, and banks have had little help or regulatory guidance to date. Resources are beginning to emerge, however: The New York Fed’s Alternative Reference Rates Committee (ARRC) recently released a Practical Implementation Checklist for SOFR Adoption, for example; private firms are also selling consulting services and tech solutions to assist with banks’ transitions.

To keep contract values even across benchmarks, those transitions will require implementing SOFR in a manner that uses spread changes to counter basis point differentials against LIBOR-pegged rates. That will get a little easier in late 2020, as more information on SOFR’s behavior should be widely available from NY Fed indices and other sources by then.

In the meantime, banks are beginning to finalize implementation plans and work with clients and partners to make necessary changes. Fifth Third, for one, is working to keep our customers and staff informed and prepared over the transition year ahead.

How It Impacts Borrowers

Bank customers with LIBOR-pegged loans should expect to hear from their banks about the SOFR change soon, and feel free to reach out if there are aspects of it they don’t understand.

Before doing so, however, customers are wise to review their existing contracts to know what kind of details are currently in place (across things like trigger events, fixed-versus-floating interest rates, loan-term timelines, and so on). These considerations may pose refinancing or payoff opportunities worth discussing with the bank before the contracts are adapted—through these are highly dependent on the borrower’s own timelines, financial goals, or business or personal circumstances.

Now is a good time for exploratory conversations about those circumstances and considerations, as banks are also still awaiting standardized or “recommended” fallback language from groups like ARRC and the International Swaps and Derivatives Association (ISDA). Once they have it, borrowers’ windows of opportunity for adapting or negotiating contracts will start to close a bit faster.

How It Impacts Investors

Fallback provisions are also a key concern of the Commodity Futures Trading Commission’s (CFTC’s) push to “be the first out of the gate to provide LIBOR-transition related relief” that doesn’t penalize market participants (promising the delivery of a series of no-action letters by 2020).

Some of those market participants grew more concerned about SOFR’s potential for volatility in August 2019, when the yield curve inversion in the repo markets was interpreted by many as a harbinger of a forthcoming economic downturn. But SOFR is expected to be stable in 2020 as its use becomes more commonplace; the first over-the-counter swaps linked to SOFR were traded and cleared in July 2019, and its use in swaps is expected to take off in a big way this year.

LIBOR had a big role in swaps, as well. Its general significance to trading means the SOFR change may affect ETFs and mutual funds in downstream ways that affect liquidity, depending on their underlying assets.

As fund managers mitigate such risks, LIBOR is still living on for now. Banks are still submitting to LIBOR through 2021, so the benchmark will stay meaningful until the clock runs out at the start of 2022. In the meantime, banks, borrowers and investors should take advantage of this time to prepare, to ensure they're well able to weather the change.

The views expressed by the author are not necessarily those of Fifth Third Bank, National Association, and are solely the opinions of the author. This article is for informational purposes only. It does not constitute the rendering of legal, accounting, or other professional services by Fifth Third Bank, National Association or any of their subsidiaries or affiliates, and are provided without any warranty whatsoever. Deposit and credit products provided by Fifth Third Bank, Member FDIC.