Insights

LIBOR and the Federal Reserve: What You Need to Know

August 2, 2021

Chances are you’ve heard the news. London Interbank Offered Rate (LIBOR), is being discontinued. But what significance does this hold? And how might it impact the U.S. financial system? This, for starters, will shake up the world of adjustable-rate loans and lines of credit. So, here’s what you need to know about upcoming LIBOR adjustments.

What is LIBOR?

The London Interbank Offered Rate, also known as LIBOR, is an index that’s commonly used to set the interest rate for adjustable-rate financial products. LIBOR is utilized in many products—but most commonly, in adjustable-rate mortgages (ARMs), corporate loans, and government bonds. In fact, Clyde & Co estimates approximately “$370 trillion of LIBOR-related activity globally,” stretching over bonds, loans, working capital and trade products, and derivatives.

LIBOR, according to Investopedia, “is based on five currencies including the U.S. dollar, the euro, the British pound, the Japanese yen, and the Swiss franc,” serving seven maturities.

The Discontinuation of LIBOR

Transitioning away from LIBOR will present one of the largest challenges to the financial services industry. Its discontinuation will shift how risk is managed by all

who use LIBOR to operate. Discontinuing LIBOR will also alter how contracts are priced.

Over time, LIBOR has been deemed less reliable. Since the financial crisis of 2007–08 even, there have been “allegations of LIBOR manipulation dating back to the 1990s or even earlier.” As a result of these allegations, various international banks received fines—which raised suspicion, which is still seen today, against the reliability of the index.

As a result, all these years later, LIBOR will be discontinued following the end of 2021. Globally, financial institutions and governments have begun to strategize alternatives to LIBOR.

In response, the Federal Reserve assembled the Alternative Reference Rates Committee (ARRC), whose objectives are to pinpoint risk-free alternative rates for LIBOR.

According to their official site, “the Federal Reserve is working with both domestic and foreign supervisors, sharing information and discussing LIBOR transition preparedness in supervisory colleges and other forums… as the global effort to transition away from LIBOR by December 31, 2021, continues.”

How Does This Affect Me?

Variable-rate loans, for example, adjustable-rate mortgages (ARMs) student loans, auto loans, and other forms of consumer credit often have their interest rates based on LIBOR. In order for a lender to replace LIBOR in your loan documents, they must send you updated documents. Whether the new documents are merely informational in nature or require your agreement will depend on the specific lender, but in all cases, it makes sense to review the details of the change. The reason is that what will likely replace LIBOR is not a simple apples-to-apples substitute.

The most likely replacement for LIBOR that you will see is called SOFR, which stands for Secured Overnight Funding Rate. There are two important differences between LIBOR and SOFR.

First, LIBOR is based on the interest rates banks charge to lend money to other banks, whereas SOFR is based on US Treasuries, or the interest rate investors charge the US government to lend it money. Whereas banks can default, it is generally accepted that the US government will not, and thus SOFR is considered a risk-free rate and LIBOR is not. Second, the “O” in SOFR stands for overnight, and a LIBOR-based loan may be based on a 30-day or 90-day rate.

Adjusting for these two differences is something all lenders must do. Reviewing these changes, perhaps with a financial adviser, may be worth your time, so that you can review any outstanding debt you have and the associated terms.