Limber up for rate reform

Rate reform has been high on the FCA agenda since 2013, arising out of the financial crisis in 2007. And this year will see Finance House Base Rate (FHBR) disappear. In this article, we consider what firms should be doing now to prepare for this.

At the same time, LIBOR (or using its full title, the London Interbank Offered Rate) will also see last orders called by supporting Banks in 2021. Beyond that, the future of LIBOR is entirely uncertain.

Why?

Largely as a result of the financial crisis in 2007, and the subsequent market abuse identified with LIBOR rates, the world of reference rate calculation is set to change.  Broadly, the three key concerns identified with LIBOR in particular were:

1. the potential for rate manipulation – further investigation of which has resulted in criminal convictions for various individuals as a result of misconduct in this area
2. the accuracy of the rates – the reference rates are calculated based on submissions of estimated borrowing costs and not actual transactions, which may differ from those estimates; and
3. the decline of unsecured interbank lending – as banks have started to use a more diverse range of funding options, unsecured interbank lending has seen a fall in popularity and consequently inter-bank offer rates may not reflect the true costs of funding, making it difficult to determine a benchmark on that basis.

As a result of the above, something known as the Benchmarks Regulation was published in order to tighten up the controls concerning reference rates, and create requirements around how and who will set reference rates.

What’s the impact?

What this means in practice is that with effect from 31 December 2019, FHBR will cease to exist and will no longer be published by the Finance & Leasing Association (FLA).  Similarly, the future of LIBOR is not certain and whilst it will continue to be published for a period, it is by no means certain for how long it will continue to exist. 

For those used to relying on FHBR, all is not lost.  With effect from 1 January 2020, the FLA proposes to calculate an adjustment to 3-month Sterling LIBOR and publish this on a monthly basis for those who want to reference LIBOR with this adjustment in their contracts but do not wish to calculate the adjustment themselves.  The FLA can do this without falling into the territory of creating a reference rate for the purposes of the Benchmarks Regulation, but if LIBOR’s future is uncertain, this may not prove to be the magic wand that many may be hoping for.

So, what’s the deal with LIBOR?  Well, to date, the Financial Conduct Authority (FCA) has confirmed that the LIBOR panel banks have agreed to continue submitting data to support the calculation of LIBOR until the end of 2021.  The FCA was keen to do this in order to avoid a sudden withdrawal of the rate which could have a detrimental impact on the financial sector, which is reassuring save that after the end of 2021 there will be no ability for the FCA to compel banks to submit data to support the calculation of LIBOR and so it is not guaranteed that LIBOR will exist post 31 December 2021.  In fact, the FCA has gone as far as to say that firms should assume that LIBOR will be discontinued and prepare for this accordingly. 

What to do next?

1. Back book:

• Contracts:
  • Firms need to review their contracts and identify if any of them reference FHBR and/or LIBOR;
  • Determine whether those contracts provide for the right to use a substitute rate or calculation, or a fall-back rate in the absence of FHBR or LIBOR;
  • If not, consider amending those contracts to replace the definition of the interest rate with a wider definition, bearing in mind any limitations on the right to vary such as the circumstances in which variation is permitted, notice periods etc;
• Tariffs of charges:
  • Identify if these refer to FHBR and/or LIBOR;
  • Consider whether updates to these documents can be made on notice to the other party or if any change has to be handled as a variation of the related document;
• Security:
  • Review existing security documents to determine whether they refer to FHBR and/or LIBOR;
  • If they do, consider whether to seek amendments to that security to deal with updating those references, noting that this could result in updated filings with various registries, and amendments to any related intercreditor deeds;

2. Forward looking:

• Update template contracts, tariff of charges and any security templates;
• Review funding agreements to determine whether a firm’s own cost of funds may be impacted by a withdrawal of FHBR and / or LIBOR;
• Review and update pricing models to ensure that they reflect the firm’s position on reference rates;
• Review and update collections and arrears policies, identify any references to FHBR and/or LIBOR and update these to align with the above.

Ultimately, given the potential need for amendments to existing contracts, firms need to start looking at this now if they are to avoid any nasty surprises six months from now.  If they don’t, and they face a challenge on the interest charges under their agreement, they may find themselves in unchartered territory as regards what interest can be recovered under their contracts.