Transitioning from LIBOR – Considerations for Mortgage Lenders

LIBOR is one of the world's most widely used benchmarks for short-term interest rates, providing an indication of the average rates at which LIBOR panel banks could obtain wholesale, unsecured funding for set periods in particular currencies. Along with the other major reference interest rates (EURIBOR and TIBOR) LIBOR is widely used in the global financial markets for a large volume and very broad range of financial products and contracts, including derivatives, bonds and loans. Whilst its administrator has not stated that it plans to discontinue the benchmark, clear messages from the regulators mean firms should work on the assumption that LIBOR will no longer be available beyond 2021[1]. This briefing considers the impact of LIBOR's discontinuation on mortgage lenders and outlines practical steps firms should be taking to ensure a smooth transition away from LIBOR.

Background – Why does LIBOR need to be replaced?

Widely publicised scandals concerning attempted market manipulation and false reporting undermined confidence in LIBOR's robustness and reliability. In addition, a key impact of the financial crisis was to bring about extensive changes in banks' funding models, in particular much less reliance by banks on wholesale interbank funding. While much has been done to strengthen LIBOR since the scandals, there is an ever-widening gap between the widespread use of LIBOR and the dwindling degree of activity in the underlying markets on which is based. Given LIBOR's "waterfall" calculation methodology[2], LIBOR panel banks submitting to the rate must increasingly supplement transaction data with expert judgement when there has not been enough market activity to base the rate on transaction data alone. Whilst uncomfortable with the conduct and other risks this brings, panel banks have voluntarily agreed to continue to support LIBOR until 2021. However, the FCA has stated that, beyond 2021, it will no longer encourage (nor will it use its powers to compel) panel banks to continue to contribute.

What will replace LIBOR?

Since April 2018, the Bank of England has been administering and publishing SONIA, The Sterling Overnight Indexed Average. SONIA is the preferred Sterling risk-free reference rate, measuring the rate paid by banks on overnight funds. It differs from LIBOR in several ways but most importantly it does not include a term bank credit risk component ("risk-free"), which makes it a better measure of the general level of interest rates than LIBOR. Another significant difference is that, while LIBOR is a forward-looking term rate, SONIA is an overnight rate.

What key challenges does this create for mortgage lenders?

It is estimated that there are currently around 200,000 LIBOR-linked residential and buy-to-let mortgages in the UK, each of which will need to be redeemed or transitioned to SONIA. LIBOR is deeply embedded in business practices and, understandably, there is a great deal of uncertainty to be addressed before many firms will feel confident in their transition programmes. Particular challenges for mortgage lenders include:

• Adjusting from LIBOR's forward-looking term rate, when as yet there is no appropriate replacement within SONIA for 3 month or 6 month term rates;
• The knock-on effect on firms' funding arrangements that changes in customer contracts could entail;
• The operational and IT systems changes required;
• The obligation to treat customers fairly and the potential conduct risk issues in ensuring that customers are not disadvantaged in the event that new rates are higher or more volatile;  
• Documentation considerations, including how Standard Variable Rate clauses may need to be adjusted and whether existing fallback clauses – typically used only for temporary LIBOR disruption – are flexible enough to accommodate a permanent change to SONIA; and
• How the changes can be adequately communicated to customers and  the appropriate consents are obtained where necessary.

However, the clock is ticking and firms should be taking concrete steps towards transition.

What can we expect from the UK regulators?

LIBOR transition solutions are industry-led rather than regulator-led, although the Bank of England established and provides the secretariat for the UK's Working Group on Sterling Risk-Free Reference Rates ("Working Group"). Membership of the Working Group's various forums and sub-groups now includes over 100 institutions including law firms, investment managers, non-financial corporates and other sterling issuers, infrastructure firms and trade associations, alongside banks and dealers. The Working Group consulted between July and October 2018 on Term SONIA Reference Rates and published the responses to that consultation in November 2018[3]. The objective of this workstream of the Working Group is to encourage production of robust term rates as soon as practicable[4].

The PRA and FCA wrote[5] to the largest institutions in September 2018 requiring information on those firms' preparations and the actions they are taking to manage transition from LIBOR to alternative interest rate benchmarks. We expect that a similar request is likely to be extended in due course to smaller institutions that were not within the first round of communications, because, in the regulators' view, "insufficient preparations for transition to alternative rates could have a negative impact on the safety and soundness of firms and cause harm to their clients and to the markets in which they operate."

Six key steps to LIBOR transition

Many firms are already well underway with their transition programmes, while others have adopted the approach of awaiting further clarity and industry convention. All will need to engage to a greater or lesser extent with the six key steps below in order to mobilise their transition efforts.

1. Identify affected contracts – Affected firms should establish the proportion of their mortgages that are LIBOR-linked.
2. Consider risks and benefits of LIBOR migration – Firms should be risk-assessing (and future-proofing) their mortgage documentation.
3. Consider SONIA-linked products – New product development teams should be working on SONIA-linked alternatives to LIBOR-linked products.
4. Customer outreach – Firms should be carefully considering their communications strategy both for new SONIA-linked products and for transition of legacy products to reduce their legacy exposure.
5. Consider risks of writing new LIBOR-linked mortgages - The Bank of England’s Financial Policy Committee is monitoring the risks associated with LIBOR discontinuation and transition. In its November 2018 financial stability report, the FPC noted with concern that the amount of contracts referencing LIBOR but maturing beyond end-2021 continues to grow. Firms should consider the range of regulatory obligations and implications should they write new LIBOR mortgages with a post-2021 maturity.
6. Engage with ongoing industry initiatives - Many affected industry bodies are actively developing LIBOR transition solutions and raising awareness both in the UK and globally. Firms should ensure that they actively engage for an opportunity to help shape and smooth the transition to risk free rates.

[1] See for example FCA CEO Andrew Bailey's speech at Bloomberg, July 2018, at which he commented "I hope it is already clear that the discontinuation of LIBOR should not be considered a remote probability 'black swan' event. Firms should treat it is as something that will happen and which they must be prepared for."

[2] For background, see ICE Benchmark Administration report "ICE LIBOR Evolution", 25 April 2018.

[3] See Consultation on Term SONIA Reference Rates - Summary of Responses, November 2018.

[4] See Working Group statement, LIBOR Transition and development of a term rate based on SONIA: Next Steps, November 2018.

[5] See joint PRA and FCA letters to the CEOs of the largest banks and insurers, 19 September 2018.

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