In a speech at the Securities Industry and Financial Markets Association’s (SIFMA) LIBOR Transition Briefing on 15 July 2019, Andrew Bailey, the Chief Executive of the FCA emphasized the need for the loan market to transition away from LIBOR ahead of 2021. He stated that market participants should not wait for the development of a forward-looking term risk free rate or rely on LIBOR continuing after 2021.
Although both the Bank of England and the Alternative Reference Rates Committee of the Federal Reserve Bank of New York (ARRC) are looking to develop forward-looking term risk free rates based on data from the overnight index swaps and futures markets, the success and timing of the development of these rates cannot be guaranteed. In any event Mr Bailey advised that forward-looking term risk free rates should only be of limited use. The prevailing view of the Bank of England Working Group on Sterling Risk Free Reference Rates (BofE Working Group) was that SONIA compounded in arrears would become more widely adopted in the bilateral and syndicated loan markets.
Mr Bailey also stated that the FCA expected banks to depart from LIBOR submitting panels as from the end of 2021. He highlighted that Regulation (EU) 2016/1011 of 8 June 2016 on indices used in benchmarks in financial instruments and financial contracts to measure the performance of investment funds (the Benchmark Regulation) placed a duty on the FCA as the supervisor of the LIBOR administrator, to assess whether LIBOR was still sufficiently representative of an underlying market or economic reality upon each departure of a panel member. This would involve not just a consideration of the size of the relevant panel but also an assessment of the underlying market being measured. It was “quite plausible” that the representativeness test would not be satisfied after the end of 2021. In any event even if LIBOR did continue for a period after 2021 it is likely that the benchmark would become more volatile as a rate and its continued use may give rise to conduct risk for banks. In addition failing to transition ahead of 2021 would also risk reversion to documentary fallbacks unsuited to long term use or to the possible imposition of regulatory fallbacks if LIBOR then ceased to be published.
Mr Bailey also directed his speech towards issues for borrowers as a result of the continued use of LIBOR and encouraged corporates to actively seek out SONIA referencing loans rather than loans referencing LIBOR. He drew attention to the fact that LIBOR builds in an element of bank credit risk which can rise during periods of financial stress even where central bank policy rates decrease. He expressed doubt that borrowers would accept their interest burden increasing rather than decreasing at times of economic deterioration. Such an element of bank credit risk premium would not be inherent in the use of a risk free rate. He noted with approval that both the LMA and LSTA are in the process of developing precedent loan agreements based upon compounded SONIA and SOFR in arrears.
Although the speech was a firm restatement of the arguments for transitioning away from LIBOR ahead of 2021, there is no doubt that this presents particular challenges for the loan market which should not be underestimated. The direction of the speech towards borrowers and the new emphasis on bank engagement with their clients regarding LIBOR transition is welcome. Although the argument that risk free rates lack inherent bank credit risk premium may be attractive to borrowers, one of the concerns for the loan market in transitioning to risk free rates is that the relevant rate will not reflect bank cost of funds in times of market stress. It will be a matter for negotiation in loan documentation referencing a risk free rate as to the extent to which provisions will be included to address that issue.