US Agencies, which include the five federal financial institution regulatory agencies and the state bank and state credit union regulators, jointly issued a statement to emphasize the expectation that supervised institutions with LIBOR exposure continue to progress toward an orderly transition away from the London Interbank Offered Rate (LIBOR). The statement includes clarification regarding new LIBOR contracts, considerations when assessing appropriateness of alternative reference rates, and expectations for fallback language. Failure to adequately prepare for the discontinuation of LIBOR could undermine financial stability, impact safety and soundness of institutions and create litigation, operational, and consumer protection risks.
The statement highlights a number of potential preparedness and risk management actions that institutions should factor into their planning for the transition:
- Clarification on the meaning of new LIBOR contracts. Given discontinuation of LIBOR, the agencies believe that entering into new contracts, including derivatives, that use LIBOR as a reference rate after December 31, 2021, would create safety and soundness risks, including litigation, operational, and consumer protection risks. Thus, a new contract would include an agreement that creates additional LIBOR exposure for a supervised institution or extends the term of an existing LIBOR contract. A draw on an existing agreement that is legally enforceable would not be viewed as a new contract. Additionally, considering the narrowing timeline involved, contracts entered into on or before December 31, 2021, should either use a reference rate other than LIBOR or have fallback language that provides for the use of a strong and clearly defined alternative reference rate after the discontinuation of LIBOR.
- Considerations when assessing appropriateness of alternative reference rates. Safe-and-sound practices include conducting the 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. As part of their due diligence, supervised institutions should understand how their chosen reference rate is constructed and be aware of any fragilities associated with that rate and the markets that underlie it.
- Expectations for fallback language. Supervised institutions are advised to identify all contracts that reference LIBOR, lack adequate fallback language, and will mature after the relevant tenor ceases. Going forward, supervised institutions are encouraged to include fallback language in new or updated contracts that provides for using a strong and clearly defined fallback rate when the initial reference rate is discontinued.
- Additional considerations. Supervised institutions are reminded of the previous agency communications and are encouraged to develop and implement a transition plan for communicating with consumers, clients, and counterparties and to ensure that systems and operational capabilities will be ready for transition to a replacement reference rate after the discontinuation of LIBOR. Supervised institutions that take a comprehensive and proactive approach will be better prepared for transitioning away from LIBOR. Supervisory focus and review will continue to increase as the LIBOR cessation date approaches.
Keywords: Americas, US, Banking, LIBOR, Risk Free Rates, Benchmark Reforms, Operational Risk, Fallback Language, Derivatives, FFIEC, US Agencies
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