Originally published in August 2019; updated in March 2021.
March 2021 - Industry preparations for the phase out of the London Interbank Offered Rate (LIBOR) will gain speed in 2021 as financial market participants continue to take stock of their exposure and transition to a new reference rate. Among the many important issues related to this transition, examining fallback language contained in contracts for LIBOR-based loans and other financial instruments, and taking steps to mitigate risks associated with inadequate fallbacks, will be a key focus for banks, credit unions, and other financial services companies.
The ICE Benchmark Administration (IBA), which publishes LIBOR in various currencies and tenors, confirmed in March 2021 its intention to extend publication of the most commonly used U.S. dollar LIBOR tenors until June 30, 2023. While this is a notable development, financial regulators and the Alternative Reference Rates Committee (ARRC), which is guiding the industry transition in the U.S., have urged all public and private market participants to continue moving forward with transition plans. Actions should include ending originations of new LIBOR-based loans as soon as possible, and no later than December 31, 2021, and protecting existing LIBOR contacts that mature after 2021 by amending them to address any deficiencies in fallback language.
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 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 by now should be executing 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.
An urgent action items for financial institutions in 2021 is addressing fallback language in contracts for LIBOR-linked loans and other financial instruments, and specifically designing fallbacks that anticipate the permanent cessation of LIBOR. The ARRC has published various resources to assist market participants in preparing fallback language for new and legacy contracts. These resources include consultations on fallback language for adjustable-rate mortgages, bilateral business loans, floating-rate notes, syndicated loans, private student loans, and securitizations, which provide voluntary guidance on creating fallbacks for these product types.
While the recommendations on fallback language are tailored for each specific product, the ARRC has followed a general framework in developing its guidelines. At a minimum, fallback language should accomplish the following:
- Define triggering events
- Identify a replacement index
- Define the spread adjustment between LIBOR and the replacement index to account for the differences between these two benchmarks
Financial institutions that are continuing to evaluate exposure to LIBOR and the adequacy of fallback language in their LIBOR-based contracts should develop and follow a structured process that considers risks, regulatory issues, and customer communications. Key steps in this process include:
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.
Develop new fallback language for new contracts
Banking regulators have issued a statement encouraging financial institutions to cease originations of new LIBOR-linked loans as soon as practical, and no later than the end of 2021, to facilitate a safe and sound LIBOR transition. Regulators have indicated that they will examine bank practices accordingly. In the event that financial institutions continue to originate new LIBOR-based loans in the coming months, the contracts should include fallback language that explicitly considers the permanent cessation of LIBOR. As previously noted, 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 (SOFR) as the recommended replacement benchmark for U.S. dollar LIBOR. The fallback spread adjustment, which accounts for the difference between LIBOR and SOFR, was fixed as of March 5, 2021 for all U.S. dollar LIBOR settings. The fallback spread adjustment was calculated based on the median spread between the relevant LIBOR tenor and risk-free rate tenor over the five-year period preceding March 5, 2021.)
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
After identifying an approach to amending fallback language, 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 and view industry resources.
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.