What you need to know about the LIBOR transition
Published April 5, 2022
The London Interbank Offered Rate (LIBOR) will no longer be used as a reference interest rate for loans and other financial instruments, with one-week and two-month USD LIBOR ceased as of December 31, 2021, and all other USD LIBOR settings ceasing after June 30, 2023. The Federal Reserve issued Supervision and Regulation Letter 21-7 on March 9, 2021 to provide separate guidance for smaller and larger institutions, in both cases focusing on six key transition areas: 1) transition planning, 2) financial exposure measurement and risk assessment, 3) operational preparedness and controls, 4) legal contract preparedness, 5) communication, and 6) oversight.
Replacing LIBOR with a transaction-based rate: SOFR
In transitioning away from LIBOR, Secured Overnight Financing Rate (SOFR) is gaining popularity as a benchmark interest rate for dollar-denominated derivatives and loans. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.
While LIBOR is based on estimated borrowing rates, SOFR is based on transactions in the Treasury repurchase market and based on data from observable transactions. Many expect the transition to SOFR to result in an increase in long-term liquidity.
The practice of transitioning to SOFR will differ for new or existing loans and financial contracts:
- New loans and financial contracts: Lenders may simply begin using the SOFR rate as the index in contracts.
- Existing loans and financial contracts: Lenders may begin using the SOFR rate but will need a legal, contractual amendment that recognizes the change in index rate.
Replacing LIBOR with the Prime rate
While LIBOR is based on the open market, Prime interest rates are tied to the U.S. Federal Funds Rate, remaining fixed until the Federal Open Market Committee meets and determines a change.
As of March 31, 2022, many banks have the prime rate set at 3.50%. While this is higher than the corresponding SOFR rate of 0.29% (or 0.17% 30-day average), the Prime rate may be desirable for businesses who are interested in less management effort or desire the lack of fluctuation.
Additional Information – Accounting-related concerns
The Financial Accounting Standards Board (FASB) issued ASU 2020-04, Reference Rate Reform, to address accounting-related concerns and allow practical expedients for contract modifications that are made until December 31, 2022, when certain conditions are met.
The main provisions of ASU 2020-04 include:
- Change in a contract’s reference rate will be accounted for as a continuation rather than a new contract (includes loans, debt, leases and others that meet certain criteria).
- Entity is allowed to preserve hedge accounting when updating strategy related to reference rate reform.
- Applicable only to contracts referencing LIBOR or other discounted reference rate.
- Will not apply to contract modifications or hedging relationships entered into after 12/31/22 except those existing at 12/31/22 for which optional expedients have been elected and retained through the end of the hedge.
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