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Transition Away from LIBOR

Insights SRD/New York Research Center

In July 2017, the CEO of the Financial Conduct Authority (FCA), Andrew Bailey, announced that the London Inter-bank Offered Rate (LIBOR) is to be phased out by 2021. With the potential discontinuation of LIBOR, preparing for the transition became unavoidable for financial market participants. 


Challenges in LIBOR Transition 


  • LIBOR is Deep-Rooted

LIBOR is widely used in various financial products and deep-rooted in financial institutes’ operating systems. It is estimated that there are $200 trillion worth of financial contracts referencing USD LIBOR, with the vast majority linked to derivatives. Transitioning away from LIBOR is an unprecedented, industry-wide shift that poses various challenges across many fronts, including liquidity/treasury, business/product, tax and accounting, legal and regulatory compliance, operational/IT infrastructure, and risk management.  


  • It is Not a Legislative or Regulatory Mandate, but regulatory authorities do monitor banks closely

Transitioning away from LIBOR is a market-driven outcome rather than a legislative mandate. In the U.S., the Alternative Reference Rate Committee (ARRC) has recommended the Secured Overnight Financing Rate (SOFR) as the reference rate. The lack of legislative underpinning makes the transition challenging to manage both from an internal operation perspective and in anticipating market participants’ behavior. Still, the ARRC and other transition-related committees and organizations are closely monitoring the progress of the transition and actively communicating with affected industry players. A slow response to changes in the market could affect a firm’s competitive position. To stay the course through this unprecedented change, firms need to come up with sophisticated transition plans and regulatory agencies monitor the transition process closely. 


Plan for LIBOR Transition 


  • Set Strategic Objectives 

Well-defined strategic objectives can guide a firm in designing its LIBOR transition roadmap, which should have clearly defined mandates and flexible implementation models. The main objectives include:    

  • Establishing a LIBOR transition program governance structure 
  • Determining internal and external communication strategies 
  • Accessing financial exposures and setting up new product pricing strategies 
  • Identifying risks associated with the transition and defining approaches to mitigate them


Establish a Governance Structure

Like everything else done in a regulated financial industry, LIBOR transition programs need to be governed by the three lines of defense, that is all the relevant first-, second-, and third-line stakeholders should be involved in the transition process. Risk and Compliance functions should be engaged in the transition program from the beginning and involved throughout to make sure the transition process complies with the regulatory requirements, and to identify key risks and suggest mitigation strategies. Internal audit formulates an independent view of the risks around the LIBOR transition program. They may challenge the program’s governance design, adequacy of the data used, and approaches in identifying exposures and analyzing the impact of the transition.  


Determine Internal and External Communication Strategies 

Given the global scope of the IBOR transition and an absence of a legislative or regulatory mandate, strategizing internal and external communication is critical. Internally, live training sessions, webcasts, newsletters, and other multi-media tools can be used to communicate a firm’s LIBOR transition program objectives, industry developments, and relevant business impacts, etc. External communications need to be consistent and effective. External stakeholders include clients, investors, regulators, trade associations, etc. Clients’ awareness and contract renegotiation need to be managed appropriately.  


  • Contracts that mature beyond 2021 need to be renegotiated and amended to reflect the transition from LIBOR to an alternative reference rate (ARR). Substituting LIBOR with an ARR impacts different financial products differently. Cash product contracts need to be negotiated between the counterparties on a case by case basis. In the U.S., the ARRC has released contract fallback languages to help market participates to amend their cash product contracts. For derivatives, a market protocol, such as the International Swaps and Derivatives Association (ISDA) market protocol, subject to counterparties’ consent to sign up to it, makes contract amendments much easier.  
  • Access Financial Exposures and Set Up New Product Pricing Strategies 


It is essential to identify, quantify, and validate financial exposures as a result of the termination of LIBOR-linked financial products. Firms may quantify their LIBOR-linked product exposures by screening balance sheet and off-balance sheet accounts to identify assets categories impacted by LIBOR replacement and further identify classes of LIBOR-linked instruments within those categories. This process requires support from all affected businesses and operations. 


The Federal Reserve Bank of New York started publishing 30-, 90-, and 180-day Average SOFR in March 2020. Firms that decided to adopt SOFR as the replacement ARR can build capacity to value SOFR-based products as part of the transition, including constructing a SOFR interest rate curve to be used for pricing SOFR-based products and calculating interest on USD loans, discounting USD denominated derivatives, and switching off LIBOR processes and infrastructure. It is important to be in line with market conventions when building the SOFR-linked pricing model and issuing new SOFR-based products. When launching SOFR-linked products, a firm needs to take hedged products timing alignment into consideration.  


  • Identify Risks and Determine Mitigation Strategies

There are material risks in the process of transitioning away from LIBOR, such as pricing risks, reputational and legal risks, operational risks, and compliance risks. Establishing a firm-wide risk management framework to oversight and mitigate the risks associated with transitioning from LIBOR is essential. The framework will help a firm to identify, measure, monitor, and control financial and non-financial risks throughout the transition.  


  • Financial accounting, reporting, and regulatory compliance considerations. 

Changing the reference rate from LIBOR to an alternative rate such as SOFR, or modifying critical contract terms of a hedging instrument can de-designate hedging relationship for the U.S. Generally Accepted Accounting Principles (GAAP) purpose. Hedges are required to be highly effective in order to achieve offsetting changes in fair value or cash flows attributable to the hedged risk. Hedge ineffectiveness can cause earnings distortion.  


Hedge accounting is complex. To ease the potential accounting burden of the LIBOR transition and facilitate its effect on financial reporting, Financial Accounting Standards Board (FASB) issued the Accounting Standard Update (ASU) to provide operational expedients and exceptions for applying US GAAP to debt contracts, fair value, cash flow, or net investment hedging relationships, as well as other transactions affected by reference rate reform.  


Tax accounting and reporting should be considered in conjunction with the accounting considerations and disclosure requirements for public or regulated companies that may require disclosure of the transition impact of tax on regulatory capital, risk-weighted assets, and deferred tax assets. In addition, contract documentation may need to be updated to ensure hedges continue to be effective. 


Amending LIBOR-referenced contracts may trigger unexpected tax consequences for both the lenders and borrowers. The United States Department of the Treasury and the Internal Revenue Service issued Proposed Regulations that provide tax breaks to taxpayers for changing the terms of debt, derivatives, and other financial contracts and replacing reference rates based on interbank offered rates with certain alternative reference rates, such as SOFR published by the Federal Reserve Bank of New York. 


  • Regulators’ Supervisory Focus

On July 1, 2020, the Federal Financial Institutions Examination Council (FFIEC), on behalf of its members, issued Joint Statement on Managing the LIBOR Transition. This statement highlighted the risks discussed in the above section and stated that “the supervisory focus on evaluating institutions’ preparedness for LIBOR’s discontinuation will increase during 2020 and 2021, particularly for institutions with significant LIBOR exposure or less-developed transition processes.” FFIEC made it clear that “during regularly scheduled examinations and monitoring activities, supervisory staff will ask institutions about their planning for the LIBOR transition including the identification of exposures, efforts to include fallback language or use alternative reference rates in new contracts, operational preparedness, and consumer protection considerations.” Notably, the discussions on transition efforts will include:


  • Identification and quantification of LIBOR exposure across product categories and lines of business; 
  • Risk assessment of LIBOR exposures, which may include scenario testing, legal review, and other analysis; 
  • Transition plans with milestones and key completion dates addressing areas such as: 
  • Strategies to inventory, analyze, and assess the risk posed by existing contracts; 
  • Strategies to identify replacement rates, modify spreads, and revise existing contracts, as necessary; 
  • Strategies to address third-party risk management; In summary, the LIBOR transition is complex, and banks needs to take a holistic approach and strategize our reform process. 
  • Potential impact on the institution’s customers; 
  • Communication plans for engaging with customers and other stakeholders; and, 
  • Plans to identify, monitor, and resolve system and other operational constraints; 
  • Management’s assessment of revisions that may be necessary to update the institution’s policies, processes, and internal control systems; 
  • Responsibility for LIBOR transition oversight (to a committee, team, or officer); and, 
  • Progress reporting to a supervised institution’s board of directors and senior management on the LIBOR transition plan. 

FFIEC expects all institutions have transition plans tailored to their LIBOR exposures: “Large or complex institutions and those with material LIBOR exposures should have a robust, well-developed transition process in place. In contrast, for smaller institutions and those with limited exposure to LIBOR indexed instruments, less extensive and less formal transition efforts may be appropriate.”  


The FFIEC’s statement does not constitute a new regulation or guidance. The existing safety and soundness standards and consumer protection laws continue to govern the operational and managerial standards relating to internal controls, information systems and internal audit systems; loan documentation; credit underwriting; and interest rate exposure.



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