The Federal Reserve’s governing body is calling on banks to cease entering new contracts that use the US dollar LIBOR as their reference rate.
Board of governors of the Federal Reserve System are urging banks to cease using LIBOR “as soon as practicable” and in any event by 31 December, 2021, when the rate is set to be discontinued.
New contracts entered into before 31 December should either utilise a reference rate other than LIBOR or have “robust fallback language” that includes a clearly defined alternative reference rate after LIBOR’s discontinuation, the Federal Reserve states.
The administrator of LIBOR has announced it will consult on its intention to cease the publication of the one week and two month US dollar LIBOR settings immediately following the LIBOR publication on 31 December, 2021, and the remaining US dollar LIBOR settings immediately following the LIBOR publication on 30 June, 2023.
The Federal Reserve warns that failure to prepare for disruptions to US dollar LIBOR, including operating with insufficiently robust fall back language, could “undermine financial stability and banks’ safety and soundness”.
Entering into new contracts that use the rate after 31 December, 2021, would create what it calls safety and soundness risks which would be examined accordingly.
If the administrator of LIBOR extends the publication of the rate beyond 31 December, 2021, the agencies recognise that there may be limited circumstances when it would be appropriate for a bank to enter into new US dollar LIBOR contracts after that period.
Richard Sharman, partner at Bird & Bird tells Airfinance Journal, that the announcement echoes similar statements by the UK regulators that banks really must stop using LIBOR in new deals.
"This goes further to say if LIBOR is used then you need to specify the alternative rate and not leave it to be agreed or specified later," he says. When the aviation senior debt market fell away due to the pandemic deals were being done based on US dollar LIBOR with the basic LMA 'agreement to agree an alternative rate' language – and whilst currently there is a reduced volume the aviation lending deals we are advising on haven’t yet changed the approach.
"But the US regulators are now saying this isn’t ok and if you use LIBOR the alternative rate actually has to be specified".
"When the aviation lending market comes back again it will need to take a step forwards on alternative rates. In other more active sectors we're seeing "rate switch" clauses being used widely – as yet there isn’t a clear market position on clause wording as some banks follow LMA and others have in-house wording that is quite different.
"Ultimately the work in other sectors will end up with a market position and the aviation lending sector can benefit from that. I would expect during 2021 if the aviation senior debt market comes back then there will be a step-change in approach and banks will focus more on pricing deals based on the alternative rate (SOFR plus a spread) at the outset.
"By then time on LIBOR will be running out and there will be pricing uncertainty if you only focus on LIBOR and not the alternative rate that will replace it," says Sharman.