January 31, 2020
The New York State Department of Financial Services (DFS) announced on Dec. 23, 2019, that it is requiring New York-regulated depository and non-depository institutions, insurers, and pension funds to submit their plans for managing the risks related to the anticipated discontinuation of the London Interbank Offered Rate (LIBOR) at the end of 2021. The DFS originally designated Feb. 7, 2020, as the deadline for submitting these plans, but has since granted a 45-day extension, to March 23, 2020.
LIBOR, once dubbed the world’s most important number, has been rocked by manipulation scandals and will be replaced by year-end 2021. LIBOR has been a widely used reference rate since 1986. It is estimated that in the US, the gross national value of financial products linked to US dollar LIBOR is approximately $200 trillion, comprising of $3.4 trillion of business loans, $1.8 trillion of floating rate notes and bonds, $1.8 trillion of securitizations, $1.3 trillion of consumer loans (held by about four million retail consumers), and $1.2 trillion of residential mortgage loans. The remaining 95% of exposures are in derivative contracts, notably interest rate swaps.1
While a large portion of these exposures are expected to mature prior to the likely LIBOR termination, regulated entities should nonetheless have specific action plans in place to address those instruments that will outlive LIBOR and manage the transition away from LIBOR.
As discussed in our April 9, 2019, insight article, the transition from LIBOR will be one of the largest risk and regulatory transformations that firms will have to undertake. At this time, firms should be in the process of assessing their LIBOR exposure (on both sides of the balance sheet) and planning their strategy to navigate the changes.
Ankura’s financial services professionals can assist clients to prepare for this transition and meet the DFS deadline by:
- Performing a readiness assessment to identify and measure the financial and nonfinancial risks of the transition.
- Designing a program to monitor and manage the transition process.
- Developing a process to analyze the impact of the transition to the institution, its counterparties, and clients.
- Developing the plan to achieve operational readiness, including related systems, accounting, and reporting/disclosure aspects of the transition.
- Building the governance framework, including oversight by the board of directors.
- Updating financial and risk models to incorporate the new benchmark rate.
- Preparing customers’ and counterparties’ communication on the transition to an alternative rate.
This transition will place a large burden on many institutions and is likely to consume operations and legal teams for the upcoming years. New contract terms will need to be negotiated, documents will need updating, and some existing contracts will need to be renegotiated, as many older contracts only include fallback language addressing the short-term absence of the benchmark rate, not the discontinuation. We recommend that treasury professionals utilize flexible fallback language in their new paper and renegotiate existing contracts to add language that gives the bank discretion to replace LIBOR with another benchmark, such as the Secured Overnight Financing Rate (SOFR), the likely successor rate.
Given many adjustable-rate mortgage and consumer loan rates are linked to LIBOR, retail customers will be impacted, bringing further exposure to reputational and litigation risk, to lenders and other consumer-facing financial bodies.
Retail customers, especially those who do not understand their loan’s rate-determining process, may believe they are being treated unfairly once they learn that their mortgage rate is changing to SOFR +280 from LIBOR +250, for instance. Even though the borrowers’ interest rate may not be materially impacted, on the perception alone, the change/increase in benchmark index and margin may convince customers that they are being harmed and have nothing to lose by refusing to agree to the mortgage contract amendments, thereby threatening timely execution. Furthermore, entities will experience additional regulatory pressure to provide transparency evidencing the consumer is not being negatively impacted.
Consumers may look to organize or seek compensation for their consent. Early, clear, and direct communication with retail customers will play a key role in reducing reputation and litigation risks.
In addition to potential litigation risks with consumers, it is expected there will be disputes and potential litigations related to contractual agreements among sophisticated parties and investors. As mentioned above, many of these contractual agreements do not plan for the discontinuation of LIBOR. We expect that disputes will arise between parties due to the lack of contractual clarity and that may result in trustees filing interpleader actions asking for courts to resolve the dispute.
Ankura’s financial services team has a long-standing track record of creating innovative solutions to assist clients in managing complex transitions, such as LIBOR transition. We offer our clients a wide range of services, spanning from full-service project planning and execution to providing subject matter experts and consulting services for specific functions, such as enterprise risk management, model risk management, credit reviews, asset valuation, strategic planning, litigation consulting, and various risk and regulatory topics.
Ankura’s experts are highly qualified, with industry-leading experience in banking, transformation, modeling, risk, credit ratings, strategy, banking products, valuation, and operational due diligence. Our team stands ready to do a LIBOR inventory and work with clients to develop and execute a plan to address this monumental transformation.
Reach out to us to discuss your firm’s LIBOR exposure and how Ankura can assist in achieving a smooth and timely transformation.
- NYS Department of Finance