LIBOR – Change is on the Way
Banks are beginning to make their Borrowers aware of the consequences that are likely to follow from the Finance World’s upcoming move to risk-free interest rates and away from LIBOR.
Background
“LIBOR” (in other words, the London Inter-Bank Offer Rate) is an interest rate that is calculated as an average of the rates at which an individual LIBOR panel bank [there are currently 17 large UK and international banks on the US$ LIBOR panel, for example] “could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to 11.00 London time”.
LIBOR is currently published for deposits made in 5 leading currencies for 7 different periods (eg Sterling for 3 months). The LIBOR for these periods and currencies is published at around 11.45 am on each Business Day on the Thomson Reuters web page.
During the period around the Global Financial Crash of 2008/9, it came to light that LIBOR had been manipulated by some Banks to their advantage. In addition, some Banks were reluctant to submit their own high borrowing rates to the panel as this might indicate to the others that they were in financial difficulty. LIBOR did not therefore reflect reality at certain times during this period.
A change in benchmark rate
The Financial Conduct Agency has confirmed that LIBOR will cease to be published from the end of December 2021. This will mean that all loans that currently use LIBOR as their reference or benchmark rate will need to use an alternative benchmark rate.
It is proposed (although not yet definitely finalised) that the new benchmark rate to replace LIBOR will be SONIA (the Sterling Over-Night Interest Average).
However, it won’t be possible to have a straight swap of these rates as (among other things) LIBOR is, put simply, a “look-forward” rate (which prices in anticipated future movements in rates) and SONIA is a “look-back” (historically factual) rate. Accordingly, there are ongoing discussions by Banks and regulators on what other adjustments might be needed to ensure the economic effect of any change from LIBOR to SONIA is minimised.
Impact on loan agreements
As a consequence of the change to a SONIA benchmark rate, each loan agreement that uses LIBOR as its benchmark rate after December 2021 will either:
- Have a benchmark interest rate that makes use of emergency “fall-back” provisions (ie the provisions that are included as a way of assessing the benchmark if LIBOR is not published or available due to market turbulence etc.); or
- Need to be amended so that references to LIBOR are replaced with references to SONIA or whatever rate is to replace LIBOR.
1. Fall-back provisions
These provisions typically contain some sort of interpolation method of calculation (for instances where LIBOR is unavailable for a brief period, but not permanently), and, failing that, a benchmark rate based on the Bank’s actual cost of funds in the inter-bank market.
In large and syndicated loans these “fall-back” clauses are often heavily negotiated, as relatively small differences in interest rates can make a significant impact, but in smaller bilateral loans they are often presented by Banks as standard and non-negotiable clauses.
Nevertheless, while “cost of funds” benchmarks can be an acceptable position for brief periods (such as in a market emergency), ultimately they are not ideal for either Banks or Borrowers in the long or medium term –
- Borrowers are unlikely to accept that they might be required to pay more interest on their loans if their Bank is or becomes less credit-worthy (the Bank’s costs of funding will mirror its standing in the market); and
- Banks in turn are not likely to want to have to admit to their Borrowers that their costs of funds are greater than those of their competitors – as in 2008/9, they may be concerned that by admitting their own high costs of funds they are showing that they are financially vulnerable.
- Amendments
It is likely in many cases to be in the interests of both Bank and Borrower for loan agreements with LIBOR benchmark rates to be amended to reflect new, SONIA based, benchmark arrangements before the end of December 2021.
The detail of what amendments will actually need to be made remains to be settled, however. It is likely that all Banks will want:
- to take a single, homogenised approach for all their affected loans, with a single set of standard amendments and new/replacement definitions; and
- for the changes to be as uncontroversial as possible – to minimise any scope for negotiation.
All parties will want the effect of the amendments to mean that the new interest rate arrangements are as similar to the old ones as possible. The ongoing discussions on LIBOR replacement show that this is not easy to achieve.
The Loan Market Association (a membership body comprising various players in the syndicated loan market) is trying to coordinate the approaches of the Banks so that (to the extent this is possible) each of them makes the same changes, and while there is no consensus or agreed position on this at the moment it is anticipated that this will emerge over the coming months.
Credit spread adjustment
As an illustration of the differences between the two rates, on 26 June 2020, 3 month LIBOR was 0.14288% (overnight LIBOR was 0.05075%), and SONIA was 0.063%. Both LIBOR and SONIA generally reflect (in different ways) the rates offered by Banks to each other in the interbank market and normally (very roughly) follow the Bank of England Base Rate.
To ensure that the cost of existing loans doesn’t change as the benchmark rate changes, it is acknowledged that there will need to be a “credit spread adjustment” to make the economic effect of a SONIA rate equivalent to the LIBOR rate.
How this “credit spread adjustment” is to be calculated has also not yet been determined. Differences in interest rate can obviously have a significant impact (in money terms) for large loans, and accordingly banks with large loan books and companies who have large debts are taking an extremely close interest in where the discussions end up.
Summary
With LIBOR ceasing to be published, most lenders and borrowers will want to amend their loan documents to refer to SONIA rather than LIBOR to provide clarity and transparency, and to avoid having to disclose (and pay) cost of funds.
Hopefully consensus will emerge on the suggested changes to be made (at least to the LMA LIBOR language) over the coming few months and it will be possible to firm up on next steps.
Unfortunately Borrowers can do little at the moment other than (i) be aware that the change to LIBOR is coming and (ii) identify LIBOR-benchmarked loans that have maturities beyond December 2021 and engage with the relevant lender as early as possible to avoid a last minute scramble.
The Banking team at FSP will continue to monitor developments on LIBOR replacement closely. Please do not hesitate to contact Alex Illingworth (or your other main FSP contact) if you have any questions on this article or if we can help in any way.
