Two Recent Statements Regarding the Use of the LIBOR Index
Back in November 2020, the Board of Governors of the Federal Reserve System (FR), Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency (OCC) issued a joint statement on managing the LIBOR Transition. One of the main provisions stated that “…agencies encourage banks to cease entering into new contracts that use USD LIBOR as a reference rate as soon as practicable and in any event by December 31, 2021.” The statement then instructs that new contracts entered into before December 31, 2021 should either “…utilize a reference rate other than LIBOR or have robust fallback language that includes a clearly defined alternative reference rate after LIBOR’s discontinuation.” Even though the joint statement encourages the discontinuation of LIBOR, the statement gives some limited uses where LIBOR may still be appropriate. These examples include:
(i) transactions executed for purposes of required participation in a central counterparty auction procedure in the case of a member default, including transactions to hedge the resulting USD LIBOR exposure;
(ii) market making in support of client activity related to USD LIBOR transactions executed before January 1, 2022;
(iii) transactions that reduce or hedge the bank’s or any client of the bank’s USD LIBOR exposure on contracts entered into before January 1, 2022; and
(iv) novations of USD LIBOR transactions executed before January 1, 2022.
In October 2021, six federal financial regulatory agencies issued another joint statement on managing the LIBOR transition to provide “…clarification regarding new LIBOR contracts, considerations when assessing appropriateness of alternative reference rates, and expectations for fallback language.”
Meaning of “New LIBOR Contracts”
The portion of the October 2021 statement that clarifies the meaning of new LIBOR contracts defines a new contract as “an agreement that (i) creates additional LIBOR exposure for a supervised institution or (ii) extends the terms of an existing LIBOR contract.” The statement specifies that a “draw on an existing agreement that is legally enforceable would not be viewed as a new contract.” The statement also suggests contracts entered into on or before December 31, 2021 should consider using a different reference rate or include fallback language. The prior November 30, 2020 interagency statement added some teeth to this announcement, by stating: “Given consumer protection, litigation, and reputation risks, the agencies believe entering into new contracts that use USD LIBOR as a reference rate after December 31, 2021, would create safety and soundness risks and will examine bank practices accordingly.” A conservative interpretation of this statement might conclude that the agencies may determine that using the LIBOR index is potentially a UDAAP violation or some other violation.
Considerations when assessing the appropriateness of alternative reference rates
The October 2021 interagency statement identified several considerations when assessing alternative reference rates. They mainly emphasize the need to conduct “…due diligence necessary to ensure that alternative rate selections are appropriate for the supervised institution’s products, risk profile, risk management capabilities, customer and funding needs, and operational capabilities.”
Expectations for fallback language
The October 2021 statement also advises supervised institutions to “…identify all contracts that reference LIBOR, lack adequate fallback language, and will mature after the relevant tenor ceases.” The agencies highly encourage the use of fallback language going forward on any new or updated contracts.
Additional considerations
The October 2021 statement concludes by encouraging institutions to:
- develop and implement a transaction plan for communicating with consumers, clients, and counterparties; and
- ensure systems and operations capabilities will be ready for transition to a replacement reference rate after LIBORS’s discontinuation.