The Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation issued a statement earlier this month encouraging banks to transition away from the U.S. Dollar (USD) LIBOR as soon as practicable. The target date for transition is the end of 2021 though recent buzz suggested the ultimate retirement may be delayed until Mid-2023 to allow banks more time to orderly transition away from the benchmark.
You may not know it, but LIBOR (acronym for London Interbank Offered Rate) plays a big role in setting interest rates for adjustable-rate loans and many types of mortgages. Basically, how it works is 18 different (international) banks collect estimates based on what they would charge each other for a loan (hypothetically), taking into consideration a variety of economic conditions. The administrator of this system, the Intercontinental Exchange (ICE) removes the 4 highest rates and the 4 lowest so that the rate cannot be distorted and then calculates an average. LIBOR is calculated in 5 currencies: USD, UK Pound Sterling, Swiss Franc, the Euro and the Japanese Yen. This average is then used in the process to determine what the rate would be for a mortgage or student loan, etc.
This transition is the result of years of discussion on alternatives resulting from concerns over the potential manipulation of the LIBOR benchmark by banks. The system that will replace it in the US is the Secured Overnight Financing Rate (SOFR) which the Federal Reserve has recommended.
Transitioning away from LIBOR will have implications for many aspects of the financial sector. Institutions large (more significantly) and small will be affected and need to be concerned with the following:
- Operational difficulty in quantifying exposure;
- Financial, valuation & model risk related to reference rate transition;
- Inadequate risk management processes & controls to support transition;
- Consumer protection related risks;
- Limited ability of third-party service providers to support operational changes; and
- Potential litigation & reputational risk arising from reference rate transition.
All these areas are important, and more detailed information can be found at https://www.ffiec.gov/guidance/FFIEC%20Statement%20on%20Managing%20the%20LIBOR%20Transition.doc.
The effect on consumers directly will come from where their loan institutions go to determine the market rate. If you think you have a LIBOR based rate (e.g., an adjustable-rate mortgage or home equity line of credit tied to LIBOR), you may want to contact your lender and find out what index they will be using in the future.