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The shift away from LIBOR: implications for retail lenders

ANALYSIS: Use of the London Interbank Offered Rate (LIBOR) as a benchmark interest rate is likely to come to an end in 2021 or shortly afterwards, with implications for millions of pounds-worth of retail banking contracts.28 Mar 2019

Financial services regulators and central banks around the world have been pushing for a transition away from the use of interbank offered rates (IBORs), given the previous attempted market manipulation, false reporting and the decline in liquidity in interbank unsecured funding markets. They include the New York Federal Reserve Bank, the Bank of England and the Financial Conduct Authority (FCA), whose director of markets and wholesale policy made the comments above in an industry speech in January 2019.

Whilst there has been understandable focus on the impact of LIBOR transition on the wholesale banking industry and especially on the £30 trillion global derivatives market, the impact of LIBOR transition on other parts of financial markets should not be forgotten. A variety of loan products reference LIBOR, such as auto finance, personal loans and credit cards, while loans and mortgages that reference LIBOR are still being issued in some parts of the market.

Those lending to consumers will have to consider how the transition affects their legacy contracts, as well as any new business still being written that still references LIBOR. There may also be other ways in which LIBOR is referenced in retail lending contracts, for example in relation to penalty rates or default rates. Retail lenders will need to consider how LIBOR transition affects funding models and risk mitigation techniques. The transition may also give rise to regulatory conduct risk and litigation risk. It is not inconceivable that more mis-selling cases connected to LIBOR could arise in the retail space.

What practical preparations can retail lenders make?

The first step is to identify contracts which are LIBOR-linked as well as any other contractual references to LIBOR, such as penalty rates. Firms should then plan their transition, taking appropriate steps from a legal, regulatory and operational perspective to transition legacy contracts and future business not only from LIBOR, but also from other IBORs, such as Euribor and the Tokyo Interbank Offered Rate (TIBOR).

Firms looking to replace LIBOR rates in legacy contracts should not underestimate the task ahead. The journey to an IBOR replacement begins with a detailed review of loan portfolios. It will be necessary to identify the relevant IBOR reference rate used and whether a fall-back position has been catered for in the contract if the reference rate ceases to be published. An assessment of whether the fall-back rate can be relied on for the remainder of the term would then need to be undertaken.

If no fall-back has been catered for, or the proposed fall-back cannot be used long term, firms are going to have to start looking to the variation terms in their contracts. Contractual variation rights will not be the end of the problem, as firms will then need to identify a risk-free rate (RFR) that is a suitable replacement (see below).

If variation terms need to be relied on, the FCA's finalised guidance on the fairness of variation terms in financial services consumer contracts will be relevant for firms. If firms have not already done so, they should consider whether their existing variation terms are fair and if the firm has the power to unilaterally vary the contract terms in the way they need. Any suggestion of unfair variation terms and consequent unfair treatment of customers will certainly attract the attention of the regulator.

What alternative reference rates are available?

Global regulators have taken steps to adopt RFRs in place of IBORs. However, these rates do not provide an exact replacement for IBORs, while there has been little uniformity in the adoption of RFRs in relation to the different IBORs, jurisdictions and markets.

The panel banks whose submissions currently inform the LIBOR rate have voluntarily agreed to continue to support it until the end of 2021, although other IBORs are likely to continue beyond this date. The Financial Stability Board, in its November 2018 progress report, said that "it is recognised that transition to RFRs may take longer and therefore maintaining IBORs is still necessary". This may present a challenge not only in relation to fall-back triggers or fall-back rates in legacy retail lending contracts, but also as regards the most appropriate alternative rates for these contracts.

RFRs such as SONIA, an overnight rate administered by the Bank of England, are not an exact replacement for LIBOR - particularly three-month and six-month LIBOR. This is likely to present challenges for lenders requiring a term rate going forward, and where they seek to replace three and six-month LIBOR in legacy contracts.

For firms, participation in relevant consultations issued by industry-led bodies such as the Bank of England's Working Group on Sterling Risk Free Reference Rates to assist in shaping transition away from IBORs in a way which is beneficial to your part of the market will be important.

What positions have the UK regulators taken?

The FCA and the Prudential Regulation Authority (PRA) set out their position on LIBOR transition in a joint 'Dear CEO' letter of 19 September 2018 (2-page / 277KB PDF). In that letter, to the largest UK banks and insurers, the regulators highlighted that insufficient preparation for LIBOR transition could negatively impact the safety and soundness of firms, their clients and the markets in which they operate. The letter sought assurances from those firms' senior managers and boards that they were making suitable preparations for LIBOR transition.

Although this letter focused on the largest firms - the so-called 'category 1' firms - lenders outside of that group may still wish to reflect not only on their own preparations for LIBOR transition, but also any related conduct risk. Areas of focus should include risks in relation to the Senior Managers and Certification Regime (SMCR) and treating customers fairly, against a backdrop where mortgage debt accounts for over 80% of total UK household liabilities and the FCA has been undertaking a mortgage market review.

There is potential for consumer detriment in relation to mortgages or loans which reference LIBOR, where LIBOR transition has been handled poorly. Firm strategies for communicating their planned changes with consumers, clients, regulators and other stakeholders should be carefully considered and planned.

Charlotte Pope-Williams is a financial regulation expert at Pinsent Masons, the law firm behind Out-Law.com.