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WBK Industry News - Federal Regulatory Developments

FDIC Releases Supervisory Insights on Potential Transition Away from LIBOR

On March 20, 2019, the FDIC released its Winter 2018 Supervisory Insights, in which it examines the future of, and potential alternatives to, the London Interbank Offered Rate (LIBOR), and provides general advice to financial institutions about planning for a potential transition away from the use of LIBOR.

LIBOR – which is calculated “as the average of the rates that panels of large banks doing business in London report that each bank could borrow unsecured from another bank in a given currency for certain specified periods” – is one of the most frequently used interest rate benchmarks, or reference rates, used in pricing a variety of financial products, including mortgage loans.  According to the FDIC, however, several problems have developed with how LIBOR is reported that have cast doubt on its continued usefulness as a reference rate and led to initiatives to transition financial markets away from LIBOR in favor of other reference rates, such as SOFR or Ameribor, by 2021. 

Such a transition, according to the FDIC, may create legal and financial risks for financial institutions, particularly in connection with legacy financial instrument documentation using LIBOR as the reference rate.  While the FDIC believes most loan agreements contain some contingency language that becomes applicable if the reference rate becomes unavailable, it notes that such language may not be clear, may not cover the situation if the reference rate becomes permanently unavailable, or may allow a change in reference rate but not in the spread over the reference rate.  Moreover, the FDIC notes that even if such contingency language exists, the substituted rate may establish an interest rate that is fundamentally different than the LIBOR-based rate, resulting in institutions and borrowers experiencing payments and valuations that differ from expectations.  

According to the FDIC, although LIBOR will likely be available for several more years, some institutions are beginning to plan for the change by evaluating their use of LIBOR.  The FDIC suggests that such proactive assessments will likely focus on: (i) the potential impact to LIBOR-linked assets, liabilities, and contracts, such as loans that mature after 2021; (ii) whether to use a different reference rate when making new loans that mature after 2021; (iii) incorporating language in new contracts that would facilitate a smooth transition to an alternative reference rate, if needed; and (iv) the comprehensive effect of risks associated with a potential transition in reference rates to the institution in areas such as information technology, management information systems, accounting, governance, compliance, and internal control structures.  In this regard, the FDIC notes that the FHFA is working on proposed contract language for residential real estate mortgages intended to be sold on the secondary market, and suggests that institutions may want to consider waiting to change interest rate language for such mortgages until the FHFA recommends or adopts standard language.  The FDIC also states that it will not be examining financial institutions for LIBOR planning or criticize risk management of loans or deposits merely because they use LIBOR as a reference rate.