Effectively implementing any big change should start with a plan. Do you know what this plan should entail for LIBOR transition?
Preparing for the transition
The discontinuation of the London Interbank Offered Rate (LIBOR) will have far-reaching effects on contracts in the financial industry, ranging from standard loan contracts to complex derivatives and debt transactions. The first article in our LIBOR transition series – “The End (of LIBOR) is Near. Is Your Bank Ready to Transition?” – discussed the background for this change and outlined steps banks might take to prepare.
While selecting and employing a replacement rate might sound simple, the transition from LIBOR will require a coordinated effort from multiple stakeholders. From contract identification to impact assessment and client experience management to status tracking, it is critical that institutions put a road map and project plan in place to prepare for the transition process.
What’s in a LIBOR transition plan?
Creating a transition plan might sound easy, but it quickly can turn from a dusting of snow to an avalanche as various components are revealed. On the surface, the task is simple: Replace references to LIBOR in contracts with an alternative rate before the index disappears. However, once institutions start to assess the hows and whats of transition, they quickly realize the many steps involved in this process.
One complicating factor of the LIBOR transition is that many institutions are considering a move to a risk-free rate such as a U.S. Treasury rate or a secured rate such as the Secured Overnight Financing Rate (SOFR), which contrasts with LIBOR as an unsecured rate incorporating the notion of credit risk. This component of transition expands the work required beyond a simple find-and-replace exercise, as the institution must understand the impact of this difference.
The Alternative Reference Rate Committee (ARRC) initially published its recommended best practices and timeline for completing the transition from LIBOR on May 27, 2020.1 ARRC updated its best practices in August 2020 to recommend adherence to the International Swaps and Derivatives Association’s Fallback Protocol for Interbank Offered Rates. ARRC issued another update in September 2020 to suggest including the ARRC-recommended (or substantially similar) hardwired or hedged LIBOR fallback language in new business loans as soon as possible, but no later than Oct. 31, 2020. While various industry publications suggest high-level milestones, the detailed planning and execution falls upon institutions to determine the best way to accomplish the underlying tasks with their unique sets of employees, contracts, and customers.
Determining appropriate steps in a LIBOR transition plan can help organizations meet the looming deadline. Along with establishing key milestones, the plan should provide a detailed timeline and delineation of responsibilities. While the ARRC summarized 10 practical implementation steps for SOFR adoption in September 2019, these steps start with the assumption that SOFR has been selected as the alternative rate.2 Institutions considering rates other than or in addition to SOFR might have additional work to do. Plans should include, at minimum, the following attributes (grouped by key stakeholder, not chronologically):
Implementation steps for SOFR adoption
Source: Crowe analysis
Executing LIBOR transition plans will require the cooperation and coordination of multiple stakeholders. Transition committees should involve more than just the credit and treasury departments. Incorporating expertise from accounting, finance, IT, and risk management and internal audit departments can help facilitate a smooth transition away from LIBOR and allow institutions to preemptively address issues they might encounter along the journey.
Assessing the implications of change
A key part of any transition is a retrospective look at whether the plan was a success, which means assessing the financial and risk impacts of the decisions made. From a financial perspective, transitioning from LIBOR will require teams to understand the impact on net interest income posed by an alternative interest rate and potentially changed credit spreads. The transition also might involve increased expense for contract originations depending on how institutions are able to integrate new rates into their existing processes.
From a nonfinancial perspective, monitoring customer retention and engagement can help inform whether the chosen transition plan was effective in educating customers on the implications of new rates. While institutions might have spent considerable time assessing and understanding new rate structures, much of this will be new for customers. Monitoring customers’ acceptance of new rates can help inform processes for communicating the intricacies of these more complex rate structures and increase the likelihood of smooth negotiations in the future.
Each replacement rate will have different risks and expectations of future rate expression associated with the index. While LIBOR transition plans will involve evaluating the potential benefits and drawbacks of each rate alternative, during the post-implementation phase it is important to continue to look at how future margins are expected to change based upon rate curve forecasts.
This analysis might involve projections over the affected portfolios to determine expectations of net interest income and margin, as compared to prior LIBOR-based expectations. Alternative rates might yield a higher or lower margin depending on the term structure of notes and the associated margins selected. Conducting this evaluation is key to determining the forecasted impact of LIBOR replacement and whether forecasted margin expectations are in line with the institution’s risk profile and risk appetite.
Maximizing the plan
The most effective project plans are those which both address known challenges and establish milestones for participants to drive accountability. While a thorough transition plan might identify likely stumbling blocks in the transition away from LIBOR, a well-designed transition plan also can help institutions to anticipate unknown challenges arising along the way. While the ARRC has designated SOFR as the recommended alternative to LIBOR, each institution must decide if it will follow that recommendation. Beyond that decision, many decisions must be made to implement the chosen replacement rate. Given the lack of current information regarding the stability of SOFR forecasts, if SOFR is the chosen replacement, institutions should allow plenty of time for impact assessment and risk mitigation to meet the ultimate transition deadline and avoid being caught flat-footed with stale contracts and an unreliable rate.
Experience shows that generating an appropriate and impactful plan allows us to prepare for uncertainty faced when solving a problem and to glean comfort from knowing that requirements were properly considered. Ultimately, proper planning will help institutions effectively employ a LIBOR replacement.
Crowe specialists have deep industry and specialized knowledge to help institutions of all sizes meet today's toughest challenges, manage a shifting landscape of risks and regulatory requirements, and improve performance.
1 “ARRC Recommended Best Practices for Completing the Transition from LIBOR,” Alternative Reference Rate Committee, Sept. 3, 2020, https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC-Best-Practices.pdf
2 “Practical Implementation Checklist for SOFR Adoption,” Alternative Reference Rates Committee, September 2019, https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2019/ARRC-SOFR-Checklist-20190919.pdf
