For the past four decades the London Interbank Offered Rate (LIBOR) has been the standard used by lenders for setting interest rates on mortgages and corporate debt. However, in 2017, financial authorities announced a phaseout of the use of LIBOR. Given the reliance on LIBOR as a benchmark for interest rates on loans, it is important that borrowers understand the implications of this transition.
How is LIBOR used?
LIBOR is calculated using estimates submitted by large banks of the rates at which they could borrow from one another, from terms of one day up to one year. LIBOR is often used as a reference rate for interest on outstanding debt, with maturities of one, three, and six months being the most popular benchmarks. For example, a company that takes out a loan from its bank may agree to pay annual interest equal to 3 month LIBOR plus three percent on its debt. Therefore, fluctuations in LIBOR create risk for businesses that have debt which uses LIBOR as the benchmark. Many businesses choose to hedge this risk using interest rate swaps, which are agreements that effectively lock in their interest rate.
Why is LIBOR being phased out?
Since the 2008 financial crisis, LIBOR has been fraught with allegations of scandal and manipulation. Because the LIBOR rates are calculated using estimates provided by 18 global banks, it is not out of the realm of possibility for banks to submit rates that do not accurately reflect their borrowing costs and therefore distort the calculation of LIBOR. As a result, regulatory agencies have been exploring other options to set adjustable-rate debt obligations.
What is replacing LIBOR?
Financial authorities decided it would make more sense to use a benchmark interest rate that reflects transactions occurring in the market, instead of a rate that relies upon quotes from a relatively small number of banks. As a result, the Secured Overnight Financing Rate (SOFR) has taken over as the presumptive replacement for LIBOR. SOFR is based on actual overnight inter-bank borrowing, and therefore, it is less prone to manipulation than LIBOR.
What is the phaseout timeline?
After December 31, 2021, panel banks were no longer compelled to submit rates for LIBOR and no new loans were able to be issued referencing LIBOR. After June 30, 2023, LIBOR will cease to exist altogether.
What are the action items for borrowers?
The transition from LIBOR to SOFR is well underway, as banks can no longer issue loans that reference LIBOR. Businesses with debt that currently references LIBOR should review any provisions for a transition away from LIBOR, as the rate will no longer be used after June 2023. Borrowers should also pay attention to the details of their loan agreements to ensure they understand how the phaseout of LIBOR will affect them. If a borrower’s lending agreement does not contain provisions related to the replacement of LIBOR, the borrower should reach out to their lender to discuss amending their agreement in anticipation of the LIBOR transition.
SOFR, the dominant replacement for LIBOR in the U.S., brings with it a welcome reprieve from allegations of market manipulation that have felled LIBOR since the financial crisis of 2008. However, as a market-based rate, SOFR brings with it some risk of its own. While LIBOR generally avoided severe short-term fluctuations, SOFR’s exposure to the whims of the market has led to some extraordinary spikes. The most notable of these spikes occurred on September 17, 2019, when SOFR increased from 2.43 percent to 5.25 percent in one day due to liquidity concerns amongst banks. This volatility may make SOFR potentially riskier than LIBOR, and strengthens the need to consider the use of interest rate swaps to hedge the rate fluctuation risk of SOFR.
Contact the Authors:
Tyler J. Baum, Advisory Staff, Audit & Accounting
Brian J. Sharkey, Director-in-Charge, Business Advisory Group
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