Although the Libor rate will be available throughout 2020, banks should be working now to outline plans, identify impacted customers, and perform impact analyses. Read our first Libor installment to understand what a Libor assessment should contain.
After completing an initial impact analysis, banks should do the following:
Run the numbers. The Federal Reserve and Alternate Reference Rates Committee suggest that banks replace Libor with the Secured Overnight Financing Rate (SOFR), which is backed by US Treasury Repos and, like Libor, reflects the rate at which banks are willing to lend to each other. However, Libor offers forward-looking tenors that factor in credit risk, while SOFR only offers a risk-free overnight tenor. Libor’s forward-looking approach makes it more resilient to economic shocks than SOFR. These differences impact both interest income cashflows and the ability to secure funding to issue loans.
To mitigate this risk, banks must consider different types of contracts – commercial loans, mortgages, swaps and options, etc., and how each will be affected by the new rate. Evaluate the level of impact to your institution’s financials with respect to different reference rates and their resilience to economically adverse events. Whether you choose SOFR or an altogether different rate, like Prime, ensure you have the impact analysis and testing to back up decisions made. Regulators have expressed interest in having documentation to support replacement rate decisions. Don’t be caught unprepared.
Based on your contracts assessment, identify where rates will need to be adjusted. Work with your vendors and internal technology partners to set up a test environment where you can run fictitious contracts with new rates. The goal of systems testing is to enable you to ‘flip a switch’ the day your institution is ready to move away from Libor. Setting yourself up for success now will lead to faster adoption later.
It’s critical to identify and communicate with every customer that will be impacted by the move. Customer needs will run the gamut from simply requiring notification of how their contracts will change to necessitating education regarding the new rate and why the change is happening. Equip your bankers and RM's with FAQs so they become a cohesive frontline of communication with customers.
As your institution continues to progress through the work effort associated with the Libor change, be sure to keep a customer-centric frame of mind. Customers will immediately feel the effect of the change, so it should be done as diligently as possible.