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What LIBOR’s end means for you

As the financial industry prepares to move away from a widely used benchmark, Brian Grabenstein, head of Wells Fargo’s LIBOR Transition Office, explains the tremendous effort that lies ahead.

August 7, 2019

Editor’s note: The financial industry is preparing for a seismic shift away from LIBOR, a benchmark rate that underlies the vast majority of floating rate financial transactions, toward a new alternative. Brian Grabenstein, head of Wells Fargo’s LIBOR Transition Office and a member of the Federal Reserve’s Alternative Reference Rates Committee, explains how this shift will affect the financial industry and consumers.


What is LIBOR and why is it important?

Brian Grabenstein
Brian Grabenstein

Let’s start with the basics. When borrowing money, there are fixed rates of interest and floating rates of interest. With a fixed rate, the interest rate remains constant for the duration of the loan. If the loan has a floating rate, then the interest rate fluctuates over the duration, typically based on an underlying index. Regardless of whether you are a large company or a homeowner with an adjustable rate mortgage, if you have a floating rate, then more likely than not your rate is set based on LIBOR.

LIBOR stands for the London Interbank Offered Rate, and it is by far the most prevalent floating rate index worldwide. The rates seek to capture what it would cost large international banks to borrow from one another in the wholesale unsecured money markets. LIBOR is actually a variety of rates, because it is printed across five different currencies and seven different forward-looking tenors — different periods of time, such as one-month or three-months — for each of those currencies. LIBOR is calculated every day when the administrator of the rate, a for-profit company, asks between 11 to 16 panel banks to estimate how much it would cost them to borrow for, say, three months in dollars, or one month in yen. The average of those numbers is LIBOR for that day. What’s happening, however, is that wholesale interbank borrowing activity has shrunk considerably following the financial crisis, so the rates submitted by panel banks are ultimately based on expert judgment, not objective transactions.

A black chalkboard displays FACT in a red box and this text: Regardless of whether you are a large company or a homeowner with an adjustable rate mortgage, if you have a floating rate, then more likely than not your rate is set based on LIBOR.

What types of transactions is LIBOR used for?

On a global basis, roughly $350 trillion worth of financial products are linked to LIBOR. Derivatives account for roughly 90% of that exposure. You’ll see LIBOR used in floating rate notes, which are a common funding tool for banks and other institutions. It’s also present in a lot of different loans — large syndicated loans, smaller business loans, and commercial real estate loans — as well as consumer products such as student loans, adjustable rate home mortgages, and some credit cards.

A black chalkboard displays FACT in a red box and this text: On a global basis, roughly $350 trillion worth of financial products are linked to LIBOR.

Why is there a need to transition from LIBOR?

I mentioned earlier how LIBOR is determined every day. As you might imagine, there’s a lot of subjectivity to the process. The panel banks are never asked to show actual transactions or point to any actual data. The subjectivity of this process led to a scandal that came to light in 2012, when it was discovered that bankers at some financial institutions were attempting to manipulate LIBOR. Since that time, a lot of good governance has been put in place, but the fundamental problem with LIBOR is that banks are being asked to estimate the cost of an activity that they don’t really do anymore. So even with enhanced governance, LIBOR is always going to have a high level of subjectivity to it. That’s really what regulators have focused on when they asked market participants around the world to identify an alternative replacement rate for LIBOR.

Animated text reads: Why is LIBOR being replaced? A. The rates are highly subjective. B. The rates are based on an estimated cost of an activity that banks don’t really do anymore. C. Both A and B. D None of the above. The answer is C.

What will LIBOR be transitioning to?

Working groups have been established in each of the jurisdictions that have a LIBOR. For each currency LIBOR, the working groups have identified an alternative reference rate and are developing plans to transition each market to the new ARR. In some jurisdictions, the new ARRs will coexist alongside other IBORs, such as Euribor in Europe and TIBOR in Tokyo, in a multirate environment. While each working group is focused on their specific currency transition, there is a global effort to work across jurisdictions in recognition of the global impacts of the LIBOR transition.

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For U.S. dollar LIBOR, the endorsed replacement rate is SOFR, which stands for the Secured Overnight Financing Rate. The endorsement comes from a body called the Alternative Reference Rates Committee, which is a public/private partnership of regulators and financial market participants convened by the Federal Reserve Board and the New York Fed. If you haven’t heard of SOFR, there’s a reason for that — it’s a new rate. The ARRC spent the better part of three years looking at all the different existing rates that could potentially replace LIBOR. What they concluded is that none of them really had the robustness, or all the features, that the market would want in a rate that will be the basis for substantially all U.S. dollar floating rate borrowings and other financial products. So the ARRC came up with this new rate, which is derived from a very robust and established overnight lending market.

SOFR is different from LIBOR in a few key respects:

  • SOFR is a secured rate as opposed to unsecured.
  • SOFR currently exists only as an overnight rate, whereas LIBOR has seven different forward-looking tenors (overnight, one week, one month, two months, three months, six months, and 12 months).
  • SOFR is administered by the Federal Reserve Bank of New York, rather than the private company that administers LIBOR.
  • SOFR is backed by roughly $800 billion in daily transactions, whereas LIBOR consists of approximately $500 million in daily transactions.

What is the timeline for the LIBOR transition?

The financial industry is being told by our regulators to be ready for a world where LIBOR no longer exists by the end of 2021. That date is tied to an agreement that the Financial Conduct Authority — the United Kingdom-based regulator that oversees LIBOR’s administrator — has with the panel banks to continue to submit their LIBOR estimates through the end of 2021. After that, we don’t have any certainty that LIBOR will continue to be published, and therefore the regulators want us to be ready for that eventuality as soon as the end of 2021.

A black chalkboard displays FACT in a red box and this text: The financial industry is being told by regulators to be ready for a world where LIBOR no longer exists by the end of 2021.

How is Wells Fargo preparing for the transition?

In February 2018, we established a dedicated program office called the LIBOR Transition Office. Chief Financial Officer John Shrewsberry felt the LIBOR transition posed a critical risk to the company and our customers. As a result, we created a stand-alone office at the enterprise level, staffed with people whose full-time focus is the LIBOR transition. I lead that office, and I have started to build a great team over the past year. Most of our senior leadership is in place. We have subject matter expertise in derivatives, cash products, and consumer products that are impacted, as well as project management, financial impact, communications, and all of the major disciplines that are necessary to have a successful transition.

Can you provide a sense of the scope of this project?

If you’re asking, “How hard is this going to be and why?” the answer is “very hard” — and there are a couple of reasons why. The first is that LIBOR is used so extensively in the financial markets. If you look across the market, there’s hardly any area that will not be affected. This is not a transition that’s limited to a subset of institutional clients, for instance. The consumer space will also be impacted, wealth management and mortgages as an example. All LIBOR-linked products will need to be updated in some manner. For some products, like an adjustable rate home mortgage, the method to calculate the interest rate adjustment will change for ARM loans that are currently based on LIBOR, which may affect a customer’s interest rate and monthly payments. Likewise, in the corporate space, loans tied to LIBOR will need to transition to an alternate rate, which may or may not be hardwired into the contract. Just about every area of the variable rate lending market has significant exposure and significant impact. I’ve heard people refer to this as a once-in-a-lifetime shift in financial market structure.

This is complicated by a number of things. I’ll mention two. The first is that the replacement for U.S. dollar LIBOR, which is SOFR, has been published for only a year. So while it’s off to a strong start, markets take a really long time to develop. There really hasn’t been enough development of the SOFR market so that it can be used as a replacement for LIBOR at this moment. We do expect the SOFR market to pick up enough to use before the discontinuation of LIBOR.

Layer on top of that a second complicating factor, which is the timeline. We have two-and-a-half years left, yet we don’t really have all of our questions about SOFR answered. That’s very challenging when you think about how many contracts are affected and will need to be amended. As a member of the Alternative Reference Rates Committee, Wells Fargo, along with other financial institutions, investors, and consumer advocacy groups, is working across the industry toward a market solution.

What will the LIBOR transition mean for customers?

Customers will need to understand the new rate, why the industry is moving away from LIBOR, and how these changes may generate the need to amend some of their transactions in the future. We’ll help them do that. We have started our customer outreach by speaking at events across the country on a roadshow of sorts, focusing on getting in front of our clients and answering their questions. As this transition is still evolving, through our seat on the ARRC, we are able to take valuable customer feedback back to the industry level.

Before we actually start using SOFR, we’ll be talking to our clients in new LIBOR-based deals about including new provisions to ensure that there won’t be any adverse outcomes if LIBOR goes away during the term of their facility. We can’t write many contracts based on SOFR quite yet, but we can make sure that we put in some really good language that acts as a safety net. We’ll be starting to roll out that language very soon.

A black chalkboard displays FACT in a red box and this text: If you look across the market, there’s hardly any area that will not be affected … The consumer space will also be impacted, wealth management and mortgages as an example.

It’s important to understand that we’re moving from an unsecured rate to a secured rate. Unsecured rates are perceived as having more risk in financial markets than secured rates. So, all else being equal, SOFR should be a lower rate. That does create some interesting questions. If you’re moving from a LIBOR-based contract to a SOFR-based contract, it’s necessary to make some adjustments to avoid creating “winners” and “losers” from an economic perspective.

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