The LIBOR transition stands to have a decidedly significant impact on the lending market, as this kind of interest rate reference transition spans across multiple areas of the lending and financial sectors. This transition will also have widespread effects globally, as many nations have previously used LIBOR as their interest rate reference.
Additionally, the transition is likely to result in increased costs and risks for lending businesses and other financial institutions as they make the necessary adjustments to keep their businesses functioning properly and in good standing in terms of compliance.
Here is a quick breakdown of some of the prominent impacts likely to be seen during the LIBOR transition for lending businesses:
- Operational Costs: Operationally, lending businesses will face an uptick in costs as they work to update their systems and acquire the necessary IT infrastructures. These costs are increased further by the need to properly document the transition as it occurs.
- Risk Management and Compliance: The movement away from LIBOR will result in necessary contract updates and amendments, as well as new and varying requirements depending on location. These kinds of amendments can take time, as well as contribute to overall cost increases as well.
- Financial Instruments: Instruments such as commercial paper, derivatives, bonds, and deposits will have their pricing and valuations significantly impacted by the transition.
- Removal of All LIBOR References: LIBOR is referenced by financial institutions and lending businesses in thousands of contracts, and the removal of these references will take a large chunk of time and money to eradicate and update to meet new requirements.
The LIBOR transition will, moreover, have significant impacts on not only all of the companies that have previously referenced LIBOR in their money borrowing or lending, but on customers and clients of lending businesses as well. This means that everything from consumer-held mortgages to credit cards face the possibility of being affected by the transition, especially in terms of interest rate increases.
Understanding how this transition will affect your customers or clients is equally important to ensuring the business itself is up to date and following compliance requirements. Communicating with consumers during this process is of the utmost importance. Here are some key examples of how consumers will experience the impact of the transition:
- Mortgages and Loans: Consumers with adjustable-rate mortgages, private student loans, and reverse mortgages are the most likely to see changes to their interest rates.
- Monthly Payments: Changes to monthly payments are likely to be a major point of concern for consumers, and lending businesses have a responsibility to be clear and communicative with their customers about their options and alternatives to help keep consumer confidence at a high level.
- Credit Cards: Credit card interest rates can be affected as well depending on if the interest rate had been previously tied to LIBOR.
Impact Analysis for Lending Businesses
Before beginning a thorough impact analysis for a lending business, any and all contracts that reference LIBOR must be identified and evaluated. This is a process that can take a considerable amount of time, as references to LIBOR can span across hundreds, if not thousands, of legal and financial documents or contracts.
This is an important step, as an impact analysis will need to evaluate and quantify all LIBOR references in order to assess and revalue existing contracts according to the new alternative interest rates that have been chosen to replace LIBOR at any given financial institution.
This process requires a high level of thoroughness and time commitment, as identifying and evaluating references can be a highly time consuming activity that can take several weeks. A proper impact analysis should also take into account many factors, and stive to answer the following questions:
- Which valuations and risk models will need to be updated?
- How will financial and/or hedging instruments be impacted?
- How many legal documents will be impacted vs. how many will be able to remain as they are?
- Which clients will be impacted, and how extreme will that impact be?
- What are the necessary fallback strategies?
The truth of the matter is that the LIBOR transition will be a fairly complex process that occurs over a long period of time for lending businesses, meaning that getting started right away is essential despite the deadline not coming until December 2021. As such, developing strategies and carrying out a thorough impact analysis as soon as possible is key.
Transitioning Over Mortgages
Transitioning over mortgages that originally referenced LIBOR is no small task, and one that historically has been done manually by lending or financial experts. However, trying to take on this kind of necessary transitional activity manually will not only be extremely time consuming, but near impossible in terms of meeting the 2021 deadline for some lending businesses who have hundreds, or even thousands, of LIBOR references spread out over their legal documents.
Luckily, there are solutions to mortgage transitions that do not require manual identification, evaluation, or extraction of information. Artificial intelligence (AI) and machine learning can be applied to these activities to help streamline the overall process. This will also drastically improve the timeliness of a lending business’ transition away from LIBOR.
AI and machine learning will ultimately help businesses and financial institutions to greatly mitigate the risk involved with the LIBOR transition, as well as vastly improving overall productivity.
Alternatives to LIBOR
LIBOR isn’t the sole way that banks use to determine rates. The Federal fund’s effective rate is what banks pay each other for overnight loans from reserves. There is the U.S. prime rate, which is used for credit card APRs.
Different countries are looking to use their own Alternative Reference Rates (ARR). The UK is planning on using SONIA, the U.S. is favoring SOFR, and Europe will be using ESTER.
In March, the UK recommended that banks cease issuing products using LIBOR. In May, the ARCC issues plans for moving forward without LIBOR and recommended a cease-issuance after June 2021. After December 2021, the FCA will no longer continue to compel banks to submit LIBOR quotes, which set an unofficial date for retiring the benchmark.
Financial institutions are already working to determine how they will move forward in the aftermath of these decisions. Many are updating contingency plans and developing alternate rates in case benchmarks like SOFR aren’t available. They are preparing to update transaction and asset documentation, preparing customers for possible new rates, and creating better interest rate models.
If your financial institution isn’t sure what is going to happen during the transition, we’re here to help. We aren’t just regular consultants, leaving clients in the dark. Our managed services offer a comprehensive package to make the transition easier, or we offer formal project options. We will do the work necessary to get our clients in line with current regulatory requirements, including the LIBOR transition and LIBOR reform.
This article was written by Homero Reyes, to speak with him further about LIBOR email us here.