Community Banking Connections

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Steps to Prepare for the Cessation of LIBOR
by Loren Lozano, Supervision Analyst, Financial Market Infrastructure Function (FMIF), Federal Reserve Bank of New York*

The financial industry is less than a year and a half away from the day when the London Interbank Offered Rate (LIBOR) is no longer guaranteed and may end. Even though the COVID-19 pandemic understandably may have caused some delays in banks’ LIBOR transition plans and efforts, the U.K. Financial Conduct Authority, which regulates LIBOR, asserted in late March 2020 that “[t]he central assumption that firms cannot rely on LIBOR being published after the end of 2021 has not changed and should remain the target date for all firms to meet.”¹ The Federal Reserve understands that COVID-19 continues to impact community banks, their operations, and their customers. Although efforts to address the impact of COVID-19 should take priority, banks of all sizes should remain mindful of the preparation needed for the discontinuance of LIBOR in the near future.

A Community Banking Connections article² last year provided background information on the transition away from LIBOR and discussed the planning efforts to move to alternative reference rates in the United States. As noted in that article, the expected discontinuance of LIBOR is important for all banks, including community banks, which may have LIBOR exposures on the asset or liability sides of their balance sheets.

This article provides a summary of the Federal Reserve’s supervisory engagement on the LIBOR transition with state member community banks, outlines the various risks that banks may face during the transition as well as steps to address them, and expands on developments in alternative reference rates.

Assessing Community Banking Preparedness

As noted in a joint statement issued by the Federal Financial Institutions Examination Council (FFIEC) in July 2020,³ key themes that banks should address in the LIBOR transition include legal risk, operational risk, and consumer risk. One source of legal and consumer risk is a lack of appropriate fallback language in loan terms or legal documents underlying financial transactions. Fallback language specifying which interest rate will be used, or a mechanism for determining the successor rate in the event that LIBOR no longer exists, can protect consumers and institutions from uncertainty and disadvantageous outcomes.⁴ As for operational risk, LIBOR may be embedded in systems, formulas, and financial models; creating cohesive solutions that replace LIBOR as an input to all of these systems and models may prove complex and challenging.

How Community Banking Organizations Can Prepare for LIBOR’s Cessation

Community banks can and should take timely steps to prepare for this transition. The first step is to understand the current level of LIBOR exposure at the bank. Typically at community banks, LIBOR may be used in some loan products, such as syndicated loans, retail mortgages, and commercial real estate/commercial mortgages, but LIBOR can also be tied to derivatives, such as interest rate swaps used for hedging purposes.⁵ Once a bank understands its exposure to LIBOR, it can use that inventory to inform its review of associated financial contracts to ensure appropriate fallback language is in place. The Alternative Reference Rates Committee (ARRC) has provided suggested contract fallback language for a variety of financial products,⁶ all of which can be found on the ARRC website.⁷ Banks with derivatives exposures to LIBOR should plan to adhere to the International Swaps and Derivatives Association’s protocol, which will be offered soon to allow participants to update the fallback language in their derivative products.

The next course of action is to assess and address operational readiness of systems and models, both those maintained within the bank and those delivered by third-party service providers. Given the prevalent use of third-party service providers by community banks, it is critical that banks confirm that these services will be updated in a timely manner. The FFIEC joint statement encourages financial institutions to reach out to third parties that provide valuation/pricing services. As noted in the FFIEC statement, for services that reference or use LIBOR as well as those that provide modeling, document preparation, or accounting, banks should determine whether the providers will be able to accommodate alternative reference rates. Additionally, systems that provide processing of loan, investment, funding, or derivative transactions should be evaluated for preparedness and transition planning.

In January 2020, the ARRC issued a survey to vendors whose products and services were identified as potentially impacted by the LIBOR transition. The purpose of the survey was twofold: (1) to provide a structure for vendors to perform a self-assessment of their readiness; and (2) to inform the ARRC and market participants on transition readiness and challenges.⁸ More recently, the ARRC has recommended specific timelines for vendor readiness as part of its best practices.⁹ Although these efforts by the ARRC may have raised awareness among vendors on assigning priority to the transition, community banks are encouraged to contact their vendors sooner rather than later to fully understand vendors’ plans for the transition of services.

Banks should then develop a strategy to address consumer protection risks and ultimately reach out to customers about transition plans. The FFIEC joint statement explains that transition plans should identify affected consumer loan contracts, highlight necessary risk mitigation efforts, and address development of clear and timely consumer disclosures regarding changes in terms. Additionally, the ARRC released reference guides for transitioning LIBOR-based adjustable-rate mortgages¹⁰ and private student loans,¹¹ which can further address consumer impact from the LIBOR transition. Consumer impact is tied to reputational risk and legal risk, and, although the transition away from LIBOR affects all banks, community banks are especially tied to their customer bases, highlighting the importance of consumer communications during the shift.

Alternative Rates

The ARRC identified the Secured Overnight Financing Rate (SOFR) as its recommended alternative rate to U.S. dollar LIBOR. The industry’s attention on the LIBOR transition to date has focused significantly on SOFR, and market participants have settled on transitioning toward SOFR for certain products, such as derivatives, once LIBOR is discontinued. However, there are other alternative rates that banks may wish to use, and community banks should conduct their own due diligence when selecting which alternative rate or rates would be most appropriate. Such considerations could include whether the alternative rate reflects the bank’s own cost of funding and whether the rate’s credit sensitivity is an important factor for the bank’s own risk management purposes.¹²

Supervisory Next Steps

In 2019, Federal Reserve state member community bank examiners were requested, on a best-efforts basis, to complete questionnaires on individual banks’ awareness and preparedness for the LIBOR transition. This was not a formal evaluation of the banks’ transition efforts, but rather an informal gathering of information to better understand themes that might merit attention within the community bank portfolio. Although the results represent responses for only a portion of the supervised community state member banks, they showed that the responding banks were aware of the transition and are in various stages of preparations. However, nearly two-thirds of the responding banks had not conducted legal contract reviews, only one-third of these banks had assessed their operational infrastructure to determine if changes might be needed, and nearly three-fourths of these banks had not developed a strategy to communicate with their customers and clients on the implications of the LIBOR transition.

Following the results of the 2019 questionnaire and similar information-gathering efforts in other supervisory portfolios, the Federal Reserve is now deepening its supervisory engagement on the LIBOR transition. For the community state member banks, Federal Reserve examiners have been gathering additional information on banks’ preparatory efforts for the transition, which will be used to inform the Federal Reserve’s understanding of industry preparedness and any gaps that banks may need to address.

Learn More About the LIBOR Transition

The Alternative Reference Rates Committee (ARRC)
Resources including the most recent guidance and Frequently Asked Questions
www.newyorkfed.org/arrc

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ARRC Fallback Contract Language
Contract language for specific products
www.newyorkfed.org/arrc/fallbacks-contract-language

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International Swaps and Derivatives Association
Information on benchmark reform and the transition from LIBOR
www.isda.org/2020/05/11/benchmark-reform-and-transition-from-libor/

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Secured Overnight Financing Rate (SOFR)
Daily SOFR statistics and other information
https://apps.newyorkfed.org/markets/autorates/SOFR