WASHINGTON—The coronavirus pandemic is dominating the agendas of every credit union decision-maker, but there is another change on the horizon that deserves attention: the move away from the LIBOR standard.
With the long-time pricing standard, the London Interbank Offer Rate (LIBOR), being phased out and a new financial reference rate taking its place, one expert says the biggest concern is not knowing how big the CU exposure may be.
LIBOR, the global benchmark short-term interest rate, which has governed global financial transactions since the 1970s, will be discontinued by the end of 2021.
Samira Salem, a CUNA senior policy analyst, said she is worried over the degree to which credit unions will have to invest both time and money in making the shift to a new reference rate, simply because no one has yet to quantify how many credit unions and how much of their products are tied to LIBOR.
And that exposure, too, could lead to potential lawsuits, she suggested, due to a lack of fallback language in many credit unions’ current contracts that include language referencing LIBOR.
“The thing is we really don't have a good handle on credit unions’ exposure,” said Salem. “It's important to get a handle on this. There is no language that explains the difference between LIBOR and an alternative rate and how that's going to be calculated.
“There certainly is legal risk,” Salem continued. “It is not clear how this situation will be resolved yet, but I am certain there is work being done now looking at this very issue. As I said, there is legal risk if neither party is willing to accept the change—either the credit union agrees to reduce its margin or the borrower pays a higher rate. This is the financial risk.”
Replacing LIBOR will be a new abbreviation, SOFR, for Secured Overnight Financing Rate. SOFR was officially adopted by the Federal Reserve in December 2017 as a replacement for the LIBOR standard, which has been widely used by financial institutions as a basis for setting—among other things—variable rate loans. The Consumer Financial Protection Bureau has estimated there is $1.3 trillion in consumer loans with an interest rate based on LIBOR, the bulk which are for residential mortgages.
According to the CFPB, LIBOR is being phased out, because the rate is based on transactions among banks that don’t occur as often as they did in prior years, making the index less reliable and credible.
Salem emphasized NCUA is paying close attention to the transition away from LIBOR within credit unions, making it one of the agency’s supervisory priorities in 2020. Board Member Mark McWatters, during a recent open board meeting, shared his concerns.
“The reason it’s high on our list is credit unions may not be paying attention to this issue; that could be the source of some embarrassment if LIBOR is to go away and the credit union community isn’t aware of it,” stated McWatters. “So, we have questions out to credit unions about how often they use LIBOR and how might they be affected by the transition.”
Earlier this year in remarks to a credit union meeting in Hawaii, McWatters added, “To me, the interesting issue isn’t the transition issue. For years people who worked with LIBOR intuitively understood the risk. You could price it in your head and had a feel for the underwriting in your head. When it becomes something else, how does that translate? How are you going to price your credit with the confidence you are properly accounting for the risk involved. In the world of pricing risk on credit, a few basis points can be the difference between a good loan and a bad loan.”
Salem said there are significant changes credit unions will have to make to their operation systems and loan documentation to accommodate an alternative base rate.
“It's going to be expensive,” said Salem. “So, how many credit unions will get hit by this and how expensive it will be over the entire system is not known today. If we can clearly determine the level of exposure we’ll get a better sense of the total cost and the total amount of work that needs to be done. There is a financial risk here, as there are a wide range of consumer products that can be affected—such as adjustable rate mortgages, student loans, home equity lines, and credit cards.”
CUNA, Salem said, has completed a “back-of-the-envelope calculation” to obtain some sense of CUs’ exposure.
“We determined around 17% the entire credit union loan portfolio is made up of adjustable-rate loans, and you can adjust that percentage up or down,” Salem said. “However, what we really don’t know is how many credit unions have loans tied to LIBOR.”
Salem reminded NCUA is encouraging credit unions to transition away from anything that uses LIBOR as a reference rate.
“The Federal Reserve has been publishing SOFR for a while, but its adoption has been slow,” Salem said. “Right now we're in the transition phase—the end of 2021 is the end date, the Federal Reserve is encouraging the use of SOFR, and financial institutions are looking at integrating fallback language into existing contracts. We're right in the middle of all this. Overall, I’d say this is a hazy area right now.”
New FSAB Guidance
To help ease some of the burdens in the move away from LIBOR, the Financial Accounting Standards Board (FASB) has released new guidance designed to “ease the process of” migrating away from reference rates that include LIBOR as well as a migration to new reference rates.
According to FASB, the guidance addresses operational challenges that are designed to “simplify matters going forward and help reduce transition-related costs.”
The update will also help reduce transition-related costs, FASB said.
The guidance will be in effect through Dec. 31, 2022, FASB said, to help various parties during the reference-rate transition period.
FASB said the new guidance provides optional expedients and exceptions for applying generally accepted accounting principles (GAAP) to contract modifications and hedging relationships, subject to meeting certain criteria, that reference LIBOR or another reference rate expected to be discontinued.
The guidance can be found here.