On December 23, 2019, the New York Department of Financial Services issued an "Industry Letter" requesting that each NYDFS-regulated institution submit the institution's plan for addressing the transition away from Libor-based credit, derivative, and securities exposures. The NYDFS letter has spurred additional focus by financial institutions in the issue, and not only by those regulated by NYDFS. This Client Alert summarizes the current state of play in Libor transition, and outlines some key considerations for developing a Libor transition plan.
In 2017, the Financial Conduct Authority -- the UK's principal bank regulator -- publicly stated that after 2021 it would no longer compel banks to furnish the data that supports Libor. Given the liability banks have faced for their Libor submissions -- often an estimate of the rate at which the institution said it could borrow as opposed to a report of an actual transaction -- it is expected that many if not most banks will cease Libor reporting. The diminished number of reporting banks, in turn, is expected to make the rate an even less reliable benchmark of low-risk, short-term private borrowing.
The five-year transition period was tacit acknowledgment that a move away from Libor would have significant implications for a huge amount of financial obligations, and time would be needed to plan accordingly. Indeed, the NYDFS estimates that the "gross notional value of all financial products linked to U.S. dollar Libor is approximately $200 trillion," with about $2.5 trillion of that tied to consumer loans and residential mortgage loans.
In response, the Federal Reserve Board and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC) to identify a suitable Libor replacement, and to recommend best practices to transition away from Libor. To date, among other things, the ARRC has: (1) selected the Secured Overnight Financing Rate (SOFR) as the recommended alternative; (2) developed "fallback language" to use in floating-rate notes, syndicated and bilateral business loans, and securitizations that incorporates "triggers" that allow selection of a replacement index (plus a margin) in the event that Libor becomes "unavailable"; (3) established a Consumer Products Working Group to address the special issues that arise in consumer transactions; and (4) established a transition checklist to assist institutions in assessing potential exposure to Libor. The ARRC's work is ongoing, and more guidance is expected on, in particular, addressing consumer contracts with Libor exposure.
NYDFS Industry Letter
Although most of the largest institutions had given the issue significant focus, many other financial entities have been waiting to determine the direction the market would take in addressing the Libor transition. The NYDFS letter, which requires the submission of a plan, has accelerated attention to Libor transition over the last three weeks. Specifically, the letter asked each regulated institution's response to describe:
(1) programs that would identify, measure, monitor, and manage all financial and non-financial risks of transition, (2) processes for analyzing and assessing alternative rates, and the potential associated benefits and risks of such rates both for the institution and its customers and counterparties, (3) processes for communications with customers and counterparties, (4) a process and plan for operational readiness, including related accounting, tax, and reporting aspects of such transition, and (5) the governance framework, including oversight by the board of directors, or the equivalent governing authority, of the regulated institutions.
Responses are due to NYDFS by Feb. 7.
Considerations for Libor Transition
Institutions should ensure their Libor transition plan includes the following considerations:
- Governance Structure
- Exposure "Triage"
- Ensure that new obligations and contracts have the necessary flexibility when Libor is unavailable or unreliable
- Categorize existing obligations to identify Libor exposure on obligations that will continue into 2022
- Counterparty Communication Strategy
- Procedural and Operational Changes