At the end of 2021, most term loans, lines of credit or other debt instruments with variable interest provisions tied to the London Interbank Offered Rate (LIBOR) will need to switch to an alternative benchmark.

LIBOR is a benchmark interest rate global banks use to lend to one another in the international interbank market. According to data provided by the Alternative Reference Rates Committee, in 2012, there were more than $200 trillion worth of transactions that were associated with LIBOR, so a change to alternative rates has been a major undertaking for the financial services industry.

Historical context for the LIBOR change explains why the transition is necessary. Additionally, it’s important to understand what impact this transition will have on any U.S. based loans that have previously used LIBOR.

What is LIBOR

To determine LIBOR rates, panels from some of the largest global banks submit an estimate of their daily borrowing to the British Bankers Association (BBA) each morning. This data is calculated for five currencies: U.S. dollar, euro, British pound sterling, Japanese yen and the Swiss franc, and allowed banks to use a global benchmark to determine borrowing interest rates. The benchmark is calculated by taking out the top and bottom 25% of quotes and averaging the remaining numbers.

LIBOR was scrutinized for market manipulation that occurred in 2008 and 2012 by certain institutions for profit. A bank’s true rate could be in the top quarter, but if they report numbers in the bottom 25%, another bank’s numbers would be lifted from the bottom 25% and used for the remaining middle numbers used to calculate the average. When multiple banks understate the rates, the average rate will be lower than it should be.

In 2008 and 2012, multiple global banks teamed up to report false numbers lower than their actual estimated borrowing numbers. While the LIBOR calculations were created on what banks estimated their daily borrowing to be, there was no way to test and verify the data for the quotes.

New alternative rates

Since LIBOR rates have proved to be subject to manipulation, LIBOR will be discontinued across all global banks. In December 2021, LIBOR rates will no longer be used for sterling, euro, yen or the Swiss franc. The U.S. will discontinue using most LIBOR rates. However, for some accounts not easily transferable, the U.S. is giving those accounts until June 2023 to fully transition.

In the U.S., the Secured Overnight Financing Rate (SOFR) is emerging as the preferred alternate rate identified by the Alternative Reference Rates Committee.

SOFR is a measure of the cost of borrowing cash overnight, collateralized by U.S. Treasury securities, and is based on directly observable U.S. Treasury-backed repurchase transactions, unlike LIBOR that was based on estimations. SOFR is not the only alternative reference rate that is emerging, however.

Market participants also are looking for an index that incorporates credit risk. One notable index is the Bloomberg Short Term Bank Yield Index, which is a proprietary index that incorporates systematic credit spreads and has a forward term structure similar to LIBOR.

Negotiating new loan agreements

While no immediate action is needed for existing agreements involving LIBOR, it’s important to be aware when entering new debt agreements or renewing agreements in 2021. Banks have been preparing for the eventual transition away from LIBOR. If your bank has not contacted you, they likely will in the normal course of business in the next few months. Depending on the maturity date for your existing variable rate debt (i.e., before Dec. 31, 2021) and the renewed maturity date (i.e., 2022, 2023 or beyond), you can likely expect at least one of these options:

• The new agreement will use a benchmark rate other than LIBOR

• The new agreement will specify LIBOR but will specifically describe the new rate (e.g., SOFR) plus prescribed rate adjustment language designed to replicate, as best as practical, the current negotiated effective rate of the LIBOR based loan

• Rather than specifying an alternative index and transition language, the language will be more general in nature to formally establish how the new interest rate will be determined when it becomes necessary

Many variable rate loans in the U.S. will not be impacted by this change since they already use a different benchmark such as a prime rate index, however, it is important to be aware of the transition as it may influence future rates and loan agreements.