Check out this adviser column featured in Crain’s Cleveland Business by Michael D. Makofsky
Banks frequently use LIBOR (London Interbank Offered Rate) to calculate the interest rate on a variety of financial products. It’s estimated that more than $300 trillion globally in loans, derivatives and other financial contracts is based on LIBOR pricing. It’s an interest rate based on submissions from banks estimating the daily interest rate for each bank to borrow money from another bank. As a result, LIBOR can fluctuate as economic conditions change.
LIBOR is currently used globally in a wide variety of financial contracts, including lines of credit, variable-rate mortgages, interest- rate swaps and corporate bonds. By way of illustration, a borrower’s interest rate is often calculated based on a LIBOR-based index plus an applicable margin. If the one-month LIBOR is 2.0% and the applicable margin is 1.5%, then the interest rate is 3.5%. If LIBOR increases, the corresponding interest rate increases by such change. Alternatively, if LIBOR decreases, the corresponding interest rate decreases by such change.
Discontinuation of LIBOR could have a significant impact on financial markets. It is paramount that an orderly transition to alternative reference rates is completed in a timely manner. Many financial institutions are already figuring out how to best transition away from LIBOR in loan transactions. Companies also need to determine their potential exposure and be proactive to mitigate possible risks.
What companies should do
Businesses need to identify existing LIBOR-based contracts that mature after Dec. 31, 2021, and determine what impact the discontinuation of LIBOR will have on such contracts. Companies should review these contracts to determine whether there is a fallback index to be used if LIBOR ceases to be published.
Many older contracts have interest-rate provisions that didn’t contemplate the discontinuation of LIBOR. In these situations, it’s unclear how interest will be calculated going forward. More recent contracts contain fallback language, but these provisions may not have been studied carefully at the time the contract was written. As a result, the post-LIBOR interest-rate adjustment may be inconsistent with a party’s expectations or create unintended results.
Companies should discuss with their financial institution how interest will be calculated going forward on their financial products so there is clarity on both sides. Financial institutions will have to amend LIBOR- based contracts to implement or clarify a replacement rate. Companies need to understand the alternative rate, how it is calculated and how it differs from LIBOR. Those differences could affect profitability, increase costs or introduce new risks for those contracts. Companies and financial institutions may need to adjust contracts to accommodate such changes.
Going forward, all financial contracts should specify an alternate rate to LIBOR and/or provide effective fallback language.