July 20, 2020 - We recently reminded asset managers that the SEC was starting to ask about LIBOR transition plans in their examinations. This week, we note that the banking regulators are doing the same thing, and they have flagged their key issues (including, in our reading, hardwired fallbacks).
On July 1, 2020, the Federal Financial Institutions Examination Council (“FFIEC”, which includes the OCC, Fed and FDIC) highlighted the financial, legal, operational and consumer protection risks that LIBOR cessation poses. It also warned that supervisory focus will increase during 2020 and 2021 and that banking examiners will ask a number of specific questions on LIBOR transition.
The FFIEC observed that Step One is assessing LIBOR risk exposure, and then determining actions to address discontinuation. They obliquely reference the “First Law of Holes”, noting that one way to reduce the LIBOR exposure is by “discontinuing the origination or purchase of LIBOR-indexed instruments.” We remind members that the ARRC’s Best Practice Recommendations strongly suggest ending LIBOR-based loan origination by June 30, 2021.
The FFIEC dedicated a whole section to fallback language, and recommended that institutions identify and address contracts with inadequate fallback language. Critically, they direct banks to consider a “hardwired” approach, noting that “new contracts should…have robust fallback language that includes a clearly defined alternative reference rate after LIBOR’s discontinuation.” The “amendment” fallback language does not identify a clearly defined replacement rate, while the hardwired fallback language does. We remind members that the ARRC Best Practice Recommendations suggest the transition to hardwired fallback language in loans by September 30, 2020 and the ARRC also released refreshed (and very workable) hardwired fallback language for loans on June 30, 2020.
The FFIEC also recommends that banks evaluate their reliance on third-party service providers and their ability to accommodate alternative reference rates after LIBOR’s discontinuation. The ARRC’s Best Practice Recommendations suggest that third party loan vendors should update their systems to handle all variants of SOFR by September 30, 2020. (Note: Banks do not need to have updated/internalized the systems by September 30th.)
The FFIEC wrapped up by providing a list of issues they will discuss in their examinations, including: i) identifying and assessing risk of LIBOR exposures, ii) transition plans with milestones and key completion dates, iii) management’s assessment of revisions to policies, processes and internal control systems, iv) responsibility of LIBOR transition oversight, and v) progress reporting to the board of directors and senior management on the LIBOR transition plan. Long story short: As the timeline for LIBOR cessation approaches 500 days, both the SEC and the banking regulators are upping their rhetoric (and, apparently, their activities) to ensure that their regulated entities are preparing. The LSTA has been engaged on these issues since late 2017; we are on the ARRC itself and co-chair the ARRC’s BLWG (and thus are very involved in the best practice recommendations, hardwired fallbacks and getting SOFR operationalized). We are happy to discuss these issues (and more) with our members on the LSTA’s Weekly LIBOR Q&A call.