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ARRC Proposes Fallback Language for Bilateral Business Loans
2019-01-15
Member Communications Archive

The Alternative Reference Rates Committee is publishing recommended fallback language for various financial products contracts as part of its plan for the LIBOR phase out.

January 2019 - Financial market participants are preparing for a phase out of the London Interbank Offered Rate (LIBOR) as a benchmark interest rate and a transition a new reference rate by the end of 2021. The Alternative Reference Rates Committee (ARRC), a body convened by the Federal Reserve, is leading this transition in the United States.

The ARRC has identified the Secured Overnight Financing Rate (SOFR) as the recommended replacement benchmark rate for U.S. dollar LIBOR and has developed a paced transition plan to help guide the industry through this transition.

One of the key considerations in the transition is ensuring that financial contracts that reference LIBOR include fallback language to address the discontinuance of LIBOR so that these contracts will still be effective under a new reference rate. The ARRC has suggested that fallback language should be consistent across asset classes in order to reduce operational, legal, and basis risk. The ARRC has also noted that some contracts for cash products referencing LIBOR do not appear to have envisioned its discontinuance.

As part of its transition plan, the ARRC is publishing recommended fallback language for market participants to consider for new issuances of various types of cash products referencing LIBOR, including business and consumer loans. These proposals are intended to offer fallback provisions that define the trigger events for a switch to a new reference rate, and allow for the selection of a successor rate and a spread adjustment between LIBOR and the successor rate to account for differences between these two benchmarks.

The ARRC is publishing its recommendations for various cash products initially in the form of consultations and is accepting feedback from the public for a limited period. The ARRC will then issue final guidance based on the consultations and feedback it receives. Recommendations issued by the ARRC for any financial product will be for market participants’ voluntary use.

To help prepare for the LIBOR phase out and transition, the Bank encourages shareholders to learn more about the ARRC’s recommendations on fallback language as they become available. A brief summary of the ARRC’s recently published bilateral business loan consultation is below, along with additional resources and information on submitting comments to the ARRC.

Fallback Language for Bilateral Business Loans

In December 2018, the ARRC published a consultation on fallback contract language for bilateral business loans that use LIBOR as a reference rate. The ARRC proposed two different approaches to developing fallback language for these loans – a hardwired approach and an amendment approach – and is accepting public comments through February 5, 2019.

  • Hardwired approach – offers a clear path and sequence of decisions for selecting a replacement benchmark and spread adjustment that would be effective if LIBOR is no longer usable.
  • Amendment approach – provides flexibility between the borrower and lender in negotiating a replacement benchmark rate and spread if LIBOR is no longer usable.

The ARRC has noted that there are benefits and drawbacks to each approach. The amendment approach maximizes flexibility for the parties to the loan agreement by providing mechanisms to facilitate negotiation of a new reference rate and spread. However, this approach may not be feasible if thousands of loans have to be amended at once because of an unexpected end to LIBOR. Such an event could disrupt loan markets. In addition, the amendment approach could favor one of the parties to the loan depending on the market environment at the time the fallback is negotiated.

Alternatively, the hardwired approach maximizes clarity upfront. Lenders and borrowers will be certain that they will receive a version of SOFR plus a spread upon discontinuance of LIBOR. Neither party would be able to take advantage of market conditions during a LIBOR cessation to gain economic value. However, the ARRC noted that term SOFR and the replacement benchmark spread do not yet exist, so it may be difficult to determine today what an ultimate replacement rate would look like.

For full details on these proposed approaches, read the ARRC’s consultation on bilateral business loans. In addition, on January 7, the ARRC posted a webinar on the bilateral business loan consultation featuring Hu Benton of the American Bankers Association, chair of the ARRC’s Business Loans Working Group. A video and presentation materials are available here.

Submitting Feedback to the ARRC
The ARRC is accepting public comments on the proposed contact language for bilateral business loans until February 5, 2019. Please see the “Submitting Feedback about Consultations” section of the ARRC’s December announcement on bilateral business loans for instructions and additional information.


Resources for More Information

ARRC Announcement on Bilateral Business Loan Fallback Language

ARRC Consultation on Bilateral Business Loans

Webinar on Bilateral Business Loans Consultation

 

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