What is in a number that we call a rate? A lot as it turns out. Over 350 trillion in financial contracts worldwide. The reference is to the upcoming LIBOR transition. Change is always hard and transition from LIBOR to ARRs (Alternate Reference Rates) is no exception. The idea is to move from rates that are based on “expert judgement” to those that are based on actual market transactions.
The LIBOR transition timeline is end 2021 but it seems that new contracts are continuing to be written using LIBOR and that a move to ARR based contracts has yet to begin in full earnest. Perhaps, it could be that LIBOR (and IBORs) are more favorable to banks, matching assets and liabilities more closely. On the other hand, ARRs may cause an asset liability mismatch for banks. Change is clearly easier when it results in positive outcomes for key players.
In a recent survey, 87% of respondents expressed concern about exposure to the LIBOR transition. But only 11% had started budgeting for the change, and only 12% had begun project plans.
National regulators don’t seem to have come down with a heavy hand yet. So, we must wait and see how this plays out. However, the New York Department of Financial Services (NYDFS) did ask institutions that it regulates to submit transition plans and associated risk. The international regulatory organization Financial Stability Board (FSB) came out and said they plan to survey national regulators to measure progress. Pressure seems to be starting to grow, top-down.
We may be entering a period of confusion around which index to use. Some deals may continue to be based on LIBOR and others on a new index. Deal documents have fallback clauses that may not work in a situation where there is no LIBOR. Analyzing documents on a transaction by transaction basis may be required to assess impact. Legacy consumer loans may present the biggest challenge with billions of dollars of residential mortgage loans and student loans that are tied to LIBOR. These may not be easy to roll over to an alternate index.
Loans linked to LIBOR may need revised fallback language to adjust to a new index. Taking stock of existing contracts to identify those are tied to LIBOR and introducing replacement language may be the best step going forward. Then, there is the work of adapting systems to deal with the LIBOR change. It has been reported that 14 of the world’s top banks expect to spend more than $1.2 billion on the transition. And that 50% to 75% of banks’ models factor LIBOR and would need redevelopment, and that most systems would need remediation.
Borrowers who had been anticipating LIBOR rates for the life of the loan and facing the potential prospect of higher rates from the move away from LIBOR may not be happy with the situation. They would like greater certainty over future liabilities and cash flow, which may not be the case with alternate rates. Since the alternate rate is based on actual transactions, borrowers may not know in advance how much interest they must pay. The ideal scenario may be to have new transactions based on alternate rates and legacy transactions continuing to refer to LIBOR with banks continuing to submit rates for the calculation of LIBOR. Treading carefully seems to be critical to avoid market turbulence and lawsuits.
To sum up, the tale of LIBOR is currently looking to have an uncertain ending despite being close to the 2021 deadline.
About the Author
Husain Khan, Head – Digital Solutions At Marlabs
Husain leads the digital transformation and new gen technologies business at Marlabs. He brings rich business development and consultative sales experience in the tech arena. Working with global leaders such as Amazon, Siemens, Deloitte, Tech Mahindra, and Schneider Electric across India, Middle East, Europe, and North America, Husain played a pivotal role in not only expanding market share but also developing new businesses from scratch. He has led many large digital transformation initiatives for Fortune 500 customers across several industry verticals including Energy, Manufacturing, Healthcare, and Hi-Tech. Prior to Marlabs, Husain was with Bidgely, a Khosla Ventures and Georgian Partners backed AI SaaS company, where he successfully built, transformed, and led some of their largest client relationships. An engineer by training, Husain holds a full-time MBA from INSEAD France.