The London Inter-bank Offered Rate (Libor) has been an important rate index used by the financial services industry in setting loan, investment, derivative, and other rates since the 1970s. Beginning in 2008, various sources began reporting that Libor rates might not be reflective of the actual rates at which major banks could borrow from one another and might be manipulated by various major banks. This situated culminated in 2012 with the disclosure of U.S. Department of Justice investigations of several banks and imposition of over $400 million in fines for Barclays Bank for the manipulation of Libor and other rates. This led to U.S. Senate calls for the transition to a U.S.-based interest rate index to replace Libor. The U.K. Financial Conduct Authority stepped in to preserve the stability of Libor but has said it will stop supporting Libor by the end of 2021.
In response to these events, the Federal Reserve created the Alternate Reference Rates Committee (ARRC) in 2014 to identify an alternate floating interest rate index. Its goals were to find an index reflective of the actual market rate for risk-free (or at least very low risk) lending and borrowing between major financial institutions and that would be less susceptible to manipulation by a small group of traders. The ARRC selected the secured overnight financing rate (SOFR) as its preferred alternative to Libor because, unlike Libor, this rate represents a broad market of actual transactions and is not subjectively set by a handful of traders viewing a thin market of trades. The SOFR is published daily by the Federal Reserve Bank of New York and is based on the current rates on repurchase agreements secured by U.S. Treasury securities. The Federal Reserve has published this rate since April 2018. It is not yet clear if SOFR will be the sole replacement for Libor for U.S. companies or it will be necessary to use other rate indices as well.
In any case, many investments, loans, interest-rate derivatives, and other instruments use rates that are tied to Libor. It will be critically important for a credit union to understand the effects that the phase-out of Libor will have on its members, balance sheet, income, and operations. The credit union should form a project team to research and plan for the necessary changes, and should include at least the following steps in the Libor transition analysis and plan:
- Prepare an accurate inventory of your credit union’s assets, liabilities, off-balance-sheet items, and other items that use the Libor index, including those processed or serviced by third parties and maintained in non-core systems.
- Conduct a risk assessment of compliance, reputation, transaction, interest rate, accounting, and other risks associated with moving the inventoried items to different rate indices. This work should consider contractual issues, systems considerations, modeling changes, testing, accounting, and member disclosures.
- Review the FASB Accounting Standards Update, Reference Rate Reform (Topic 848). Generally, this Update provides guidance to ease the effects that hedge and contract modification accounting standards might otherwise require for changes in reference rates.
- Stop entering new agreements immediately that will lock the credit union into using Libor going forward.
- Understand the effects that the cessation of LIBOR will have on each product such as mortgages, home equity loans, credit cards, commercial loans, and lines of credit.
- Reach out to vendors to understand their plans for moving to new rate indices and monitor their actions to ensure they stay on track to complete their project plans.
- Determine the new rate indices the credit union will use for each affected product and analyze any changes the new indices might have on expected net interest margins and the volatility of such margins in ALM scenarios.
- Modify procedures appropriately to incorporate the necessary changes.
- Test the new products and procedures to ensure they will support smooth operations with minimal effects on earnings and member relations.
- Communicate the changes to members in a clear manner well in advance of the Libor cessation date.
Your credit union might identify a great deal of balance sheet items that will be affected by the cessation of Libor or might have relatively limited implications. In either case, it is important that you begin your analysis and transition plans soon to avoid greater disruptions and costs at the last minute.
If you have any questions regarding the above information or there is any way we might be able to assist you, please do not hesitate to reach out. Also, be sure to visit the Rochdale Paragon blog at https://rochdaleparagon.com/insights/ for more information and other great insights.