The Financial Conduct Authority (FCA) will not compel banks to submit LIBOR quotations, or sustain the LIBOR benchmark, after 2021.
Acknowledging that many lenders' transition plans had been disrupted by Covid-19, the Working Group on Sterling Risk Free Rate Transition (the Working Group) and the FCA published changes to the interim LIBOR transition milestones on 29 April 2020.
The first key milestone affected is the deadline by which the cash market is recommended to stop issuing sterling LIBOR-referencing loan products. This deadline was extended from the end of September 2020 to the end of March 2021.
This extension was welcomed by most financial institutions dealing with the implementation of government-backed lending schemes and numerous requests from borrowers.
Lenders should, however, be able to offer non-LIBOR linked products to borrowers by the end of September 2020.
Despite the changes to the interim LIBOR transition milestones, the central assumption remains that firms cannot rely on LIBOR being published after the end of 2021.
This article examines the potential risks for borrowers entering into new contracts referencing LIBOR and extending beyond the end of 2021 and how to address those risks.
What are the potential risks for borrowers?
First, voluntary LIBOR submissions may continue beyond December 2021. In that case, the published LIBOR is unlikely to be representative of the market.
Arguably, some fallback provisions, which provide for alternative methods of calculating the interest rate where the relevant LIBOR screen rate is unavailable, would not be triggered and a non-representative LIBOR would apply.
This may raise potential disputes as to what interest rate should be paid.
The UK Government announced on 23 July 2020 that it intends to introduce new legislation to give the FCA powers to require an administrator of LIBOR to alter its methodology in calculating the benchmark if LIBOR ceases to be representative.
However, there is no guidance yet (and it seems unlikely that there will be for some time) as to what new methodology will be used, and the FCA accepts it may not be able to create a new methodology for all LIBOR tenors/ currencies.
Second, there are some common historic fallback provisions typically found in financial agreements such as:
• Reference bank rate: An arithmetic mean of quotations typically provided by four reference banks. However, if LIBOR is withdrawn, banks might not be willing to undertake the liability risks of making submissions voluntarily to other market participants. Quotations may therefore be unavailable.
• Historic screen rate: Applies the most recently available screen rate. This will convert the contract from a floating rate to a fixed rate agreement, fundamentally altering the economics of the contract. This is plainly undesirable in circumstances where the parties cannot predict who would benefit.
• Cost of funds calculation: Requires the lender to determine its reasonable costs of funding the particular transaction. Banks do calculate their cost of funding, but on a portfolio basis. Deriving the cost of the particular transaction from the portfolio as a whole is necessarily imprecise and subjective, and could be open to challenge.
Those fallback provisions were designed for temporary interruptions to LIBOR. They are ill-suited to the cessation of LIBOR entirely and may give rise to litigation and should not be used in new LIBOR loans entered into in the current situation.
Third, borrowers must consider the risks associated with related transactions. For example, if a borrower is party to derivatives associated with its loan product, the fallback provisions for the two instruments may operate differently and/or be triggered at different times. This may cause mismatches on payments and impact the borrower's funding arrangements.