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Preparing for the LIBOR Transition: Fallback Language
2019-08-21
Member Communications Archive

August 2019 - As the financial services industry readies itself for the expected phase out of the London Interbank Offered Rate (LIBOR) at the end of 2021, banks, credit unions, and other market participants are taking stock of their LIBOR exposures and beginning to plan accordingly. FHLBank Atlanta has published a series of articles to help explain why LIBOR is going away, what will replace it, and how financial institutions can start preparing for the transition. In this article, we take a closer look at a key area of preparation: fallback language found in LIBOR-based contracts.

What is fallback language and why is it important?

One of the biggest questions financial institutions are grappling with is what happens to LIBOR-based cash products (adjustable-rate loans, floating-rate notes, etc.) when LIBOR is no longer available? Loan agreements for LIBOR-based products typically include a definition of LIBOR, and within that definition, certain “fallbacks” in case LIBOR cannot be determined based on the method provided in the agreement. This method is typically a designated display page on a Bloomberg or Reuters rate screen.

The fallbacks in legacy agreements for LIBOR-based cash products are generally designed to address what happens when LIBOR is unavailable on a temporary basis. For example, the rate does not appear on the designated screen because of a systems error or temporary market disruption. In such a case, the fallback provisions may allow for the application of an alternate base rate, which could be the rate used in the previous period or another reference rate, such as the Prime Rate or Fed Funds rate, or fallback to the last published LIBOR rate. 

While these fallbacks are practical for short-term unavailability of LIBOR, they are likely not viable as long-term solutions when LIBOR becomes permanently unavailable or no longer exists. Alternate rates are different from LIBOR and may materially alter the economics of the loan agreement, potentially creating “winners” and “losers” over the longer term. Resorting to the last LIBOR publication in the event of a permanent discontinuation effectively would convert an adjustable-rate loan into a fixed-rate one. A fundamental tenet of sound fallbacks is that parties to the agreement should be in the same economic position once fallback provisions are triggered as they were prior to the triggering event. 

Preparing new fallback language

There are numerous actions financial institutions should be taking today to minimize risks associated with fallback language. Financial institutions should have, or should soon develop, a staged transition plan to manage the move away from LIBOR. This plan is critical for ensuring operational readiness and effective risk management, and for demonstrating preparedness to regulators, which are increasing their focus on the LIBOR phase out. 

A core component of any transition plan is addressing contractual fallback language and specifically designing fallbacks that contemplate the permanent cessation of LIBOR. Resources related to fallbacks are available and will be released on an ongoing basis from the Alternative Reference Rates Committee (ARRC), the industry body that is overseeing the LIBOR transition in the U.S. As of July 2019, the ARRC has published consultations on fallback language for adjustable rate mortgages, bilateral business loans, floating-rate notes, syndicated loans, and securitizations. These consultations provide voluntary guidance on creating fallbacks for these product types.

While the guidance is very specific to each individual product type, there are a few overarching steps that financial institutions can reference as they begin addressing deficiencies and risks associated with legacy fallback language: 

Identify scope and scale

Financial institutions should identify the product areas that will be affected by the LIBOR phase out and how legacy fallback language in contracts for these products works. This is particularly important for contracts that mature after 2021; however, it is worth reviewing all LIBOR-based contracts since there is potential for LIBOR to become unreliable or unavailable before its anticipated cessation at end of 2021. For example, LIBOR could deteriorate to an extent where its liquidity or usefulness to market participants is negatively impacted. At this point, the regulatory supervisor for LIBOR’s administrator could publicly announce that benchmark is no longer representative of the underlying market. 

Develop new fallback language for new contracts

Despite the anticipated phase out of LIBOR, market participants are continuing to enter into new LIBOR-based contracts today. Going forward, financial institutions should create and implement new fallback language in LIBOR-based contracts that explicitly considers the permanent cessation of LIBOR. The language should identify the trigger events for the fallbacks and define the use of an alternative base rate and provisions for spread adjustments. (Note that the ARRC has selected the Secured Overnight Financing Rate as the replacement benchmark for U.S. dollar LIBOR.)   

Fallback language should balance flexibility with the need to provide as much certainty as possible to the parties of the contract. As noted previously, it should also ensure that there are no “winners or losers” and that parties retain their economic positions relevant to one another once the fallbacks are triggered. 

Develop fallback language and implementation plans for existing contracts 

One of the most challenging aspects of the expected LIBOR phase out is how to amend fallback language in existing LIBOR-based contracts that will mature after the phase out occurs. The first steps in this process are to review existing agreements to determine how amendments can be made, along with the consent required of the counterparties to change terms. Typically, credit agreements require the consent of the borrower and all lenders to amend an interest rate or other economic term. As with fallback language for new contracts, amended language should be more flexible than legacy language, consider the permanent cessation of LIBOR, identify fallback trigger events, and specify an alternate reference rate. 

Communicate with customers and other counterparties

As an approach to amending fallback language becomes clearer, financial institutions should begin communicating with customers and clients to inform them of the transition steps and conversion methods. Key questions and topics to address include consent requirements and methodologies, the definition of a replacement benchmark rate, and explanations of why a spread may be different under the new rate, when compared to LIBOR. 

Risks of not addressing fallback language

As noted above, fallback language should ensure that parties to the contract are in similar economic positions once the fallback is triggered. The economics of an agreement can shift over the long term and failure to address fallback language could result in issues with enforceability of the original contract and possible litigation by the counterparty. 

Additionally, it’s important for financial institutions to address legacy fallbacks for their own financial stability. Financial institutions, as much as their customers and counterparties, will benefit from having greater certainty of what will happen to LIBOR-based contracts once the phase out is complete. There are implications for continuity of contracts, income stability, and balance sheet hedging effectiveness that need to be examined when planning for the LIBOR transition.

 

For more information on the LIBOR phase out, read other articles in our series:

A Primer on LIBOR’s Phase Out and Transition

Preparing for the LIBOR Transition

The FHLBanks Play an Important Role in the LIBOR Transition

 

Sources:

Oliver Wyman and Davis Polk. “LIBOR Fallbacks in Focus: A Lesson in Unintended Consequences.” 2018.

Harrington, Gregory and Caraballo, Arturo. “The End of LIBOR.” June 11, 2019.

Deichler, Andrew. “Libor Fallback Language: What Treasurers Need to Know.” April 24, 2019.

 

The Federal Home Loan Bank of Atlanta is not a registered investment advisor. Nothing herein is an offer to sell or a solicitation of an offer to buy any securities or derivative products. You should consult your own legal, financial, and accounting advisors before entering into any transaction. Interest and advance rates presented in this article are for illustrative purposes only.

 

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