How to Prepare Your Business For LIBOR Loan Phase-Out
If your business has a LIBOR-based loan, change is coming your way. LIBOR, the London Interbank Offered Rate, is being eliminated as an interest rate index – on a global scale. It’s not a question of “if” it will affect your business, it’s a definitive “when.” And that “when” starts now.
No new LIBOR loans should be issued after 12/31/21 – that’s next month. And existing LIBOR-based loans will need to be transitioned to an alternative index by 6/30/23 because the 30-day LIBOR index will no longer be published after that point. That’s just 19 months away. Ahead of the deadlines, some banks have already begun proactively addressing the situation. You should do the same for your business.
How will the LIBOR transition impact your business?
- It could affect one loan, or dozens, or hundreds, or even more, and likely from more than one financial institution – each of which may have a different LIBOR transition strategy.
- Your credit spread will likely be higher.
- Your all-in monthly loan costs could change once you shift away from LIBOR.
- Your loan payment amount and process may change.
- You may have to make operational and accounting systems changes to adapt to new reconciliation, accrual, and billing processes.
- You may have to train your finance team on how to manage the transition across your enterprise.
- You may already be getting non-LIBOR loans, as some banks have moved up their internal deadlines ahead of the 12/31/21 transition.
- You may have added negotiating power for new loans closing between now and 6/30/23.
Let’s take a closer look at what’s going on and what you should be doing now.
What Is LIBOR?
The London Interbank Offered Rate is a global benchmark banks have used to gauge funding costs and investment returns for financial contracts since 1986. It’s calculated in 5 currencies, including U.S. dollars, UK Pound Sterling, the Swiss Franc, the Euro, and Japanese Yen. LIBOR uses a standardized, transaction-based, data-driven layered method administered by the Intercontinental Exchange (ICE). Simply put, ICE asks 18 major banks what they would charge other banks for short-term loans and calculates Daily and Term LIBOR rates based on that information.
LIBOR has been used for — and could impact:
- Commercial loans
- Adjustable-rate mortgages
- Swaps, derivatives, and hedges
- Municipal bonds
- Credit cards
- Private student loans
- Asset-backed securities
- Other financial products
Why Is LIBOR Being Replaced?
In short, it has come to be seen as a less indicative benchmark because of the way information is submitted and because it can be subject to manipulation.
In 2014 the Alternative Reference Rates Committee (ARRC) was formed by the Federal Reserve Board to build a strategy for U.S. banks to transition away from LIBOR. In June 2017, the ARRC recommended the Secured Overnight Financing Rate (SOFR) as LIBOR’s successor. The N.Y. Federal Reserve began publishing daily SOFR in 2018. It is considered a preferred replacement for LIBOR because it is based on real transaction data from the Treasury repo market, making it less likely to be manipulated.
The ARRC set the spread adjustment from LIBOR to SOFR at 11.4 basis points, which is the 5-year average historical difference between LIBOR and SOFR. Today SOFR rates are about 5 basis points and LIBOR rates are about 9 basis points – certainly a difference of less than 11.4 basis points. LIBOR and SOFR have typically moved in a similar direction historically. However, depending on the index rates at the time of conversion and in the future, borrowers could sometimes end up with higher interest rates under SOFR, and lower rates at other times. Lenders can take steps, such as adjusting interest rate floors, to minimize the rate change at the time loans are converted from LIBOR to SOFR.
To read more about the history of LIBOR and the transition, check out this recent Forbes article: “What Is Libor And Why Is It Being Abandoned?”
What Can I Do To Prepare My Business for LIBOR Transition?
Many banks are already preparing for the transition. In fact, it’s estimated large global banks may each spend as much as $100 million on the LIBOR transition. Each bank has the autonomy to address the transition independently. Unfortunately, this means different banks will likely have different approaches, adding complexity to your business’ own transition processes if you have loans with multiple lending institutions.
Nine Steps to Take Now
Here are the nine steps to take now to prepare your business for LIBOR loan transition:
1.) Determine whether your existing LIBOR loans will mature before the 6/30/23 expiration date. Loans that mature prior to that date will not be affected if your bank opts to not modify the loan.
2.) For existing loans that do not mature before 6/30/23, you will need to work with your bank to determine which of the following strategies will be applied:
- Modify the LIBOR loan to SOFR or another index.
- Plan for the LIBOR loan to fall back naturally on 6/30/23 according to the fallback provision in the loan agreement.
3.) You may already have heard about steps your bank – or banks – will be taking to transition your LIBOR loans. If not, the time to ask about their strategy, their preferred index, and their timeline is now.
4.) Review each of your existing loan agreements by looking at the “definition of index” section to determine whether they are LIBOR-based loans and what fallback strategy is outlined. The loan agreement should contain language defining what happens if the index being used, in this case LIBOR, is no longer available.
5.) Calculate potential impacts to your rates and payments based on the ARRC recommended spread adjustment and the credit spread difference between LIBOR and SOFR.
6.) For new loans that will be closing before 12/31/21, it is likely best to work with the lender to see if they can use SOFR or another rate index, instead of LIBOR.
7.) If you have hedges, derivatives, or swaps tied to your loan, work with your bank to determine next steps, as these have unique transition-related approaches.
8.) Plan for operational, software, human capital, and other changes your business will need to effectively manage the transition.
9.) Start following the SOFR index at Daily SOFR and Term SOFR
There’s no question this is a mega-event for the finance industry — and, as a result, for your business. Now is the time to get the information you need to make decisions and start planning so you can strategically manage this transition as smoothly as possible.
We are here to help! To find out how we can help assess your current loans, minimize cost increases, and manage internal changes in operations, technology, and staffing related to the LIBOR transition, contact Fahrenheit Advisors and Fulton Bank.
About the Authors
Keith Middleton is a Co-Managing Partner and Co-Founder of Fahrenheit Advisors. He oversees the firm’s consulting and fractional services, as well as risk management and operations. He is a member of Fahrenheit’s Leadership Team. A seasoned corporate finance executive, Keith’s expertise in organizational strategy and a newfound passion for entrepreneurism has helped Fahrenheit expand across multiple service lines and geographies.
Whit Buckwalter is Senior Vice President and Director of Syndication Banking for Fulton Bank, a subsidiary of the Lancaster, PA-based Fulton Financial Corporation. In this role, Mr. Buckwalter oversees high-dollar, multi-bank transactions for large commercial clients.