How CFOs Can Smooth Out the Switch from LIBOR to SOFR

Welcome to the beginning of the end for LIBOR. Though the transition from LIBOR to SOFR has been underway since 2017, as of 2022, new-issue LIBOR contracts are officially a thing of the past, and the countdown begins toward a wholesale phase-out in mid-2023.

Blame Murphy’s Law, but the realities of 2022 threaten to make the transition a bumpy one. Chief among them is volatility in SOFR-LIBOR spreads caused by the resurgent pandemic and a shifting monetary outlook (rate hikes; accelerated Fed tapering). As market spreads shrink relative to the recommended spread adjustments on outstanding LIBOR contracts, those contracts begin to look pricey to issuers. That could trigger a wave of early refinancing to bring down costs.

Needless to say, this coming year and the first half of 2023 will be pivotal for CFOs managing their own LIBOR-to-SOFR transitions. Finance leaders need a plan now to move into the post-LIBOR era.

Executing the transition from an organizational standpoint is a massive undertaking. With LIBOR (which has been called the world’s “most important number,” no less) serving as the de facto interbank lending rate for decades, any borrowing entity—from small businesses up to large multinationals—likely has some exposure to the shift. More than likely, LIBOR has wound its way into an untold number of systems, processes, forecasts, and more.

At Bank of the West, we’re working to keep our clients informed of market developments during the shift to SOFR. Our roadmap, and that of many other financial institutions, looks like this:

• At our bank, and many other financial institutions, legacy loans will continue to be based on LIBOR through either the maturity of the loan or to June 30, 2023, at the latest.
• After June 30, 2023, all LIBOR-based loans will move to SOFR.
• As of January 1, 2022, newly originated loans now reference SOFR.

Naturally, this timeline comes with an array of cascading challenges for lenders and corporate borrowers alike.

If you haven’t already, it’s time to initiate a grand fox hunt of sorts to chase down the LIBOR provisions hiding in contracts and systems throughout your organization. Which lending or financing agreements are affected? How will the repercussions play out? What changes are needed to make room for SOFR?

The answers will undoubtedly lead to—or have already led to—some mix of funding-cost recalibrations, tweaks to accounting and ERP systems, and new procedures to rid LIBOR from operations altogether.

With deadlines looming, time is of the essence. Here’s a roadmap to help you navigate the switch.

What’s the Difference Between LIBOR and SOFR?

LIBOR has been in use since the mid-1980s. The Intercontinental Exchange, or ICE, calculates the rate daily by asking global banks to quote the rate they’d charge other banks for certain types of short-term loans. Then ICE generates a trimmed average, with the highest and lowest quotes removed, and publishes it. Banks use the rate to calculate the rate on unsecured bank-to-bank loans.

To eliminate the risk of manipulation during the quote-reporting process, SOFR takes a different approach. It relies on rates from actual transactions of repurchase agreements, or repos, in the US Treasury markets, as opposed to LIBOR’s forward-looking rate estimates. As collateralized—and therefore secured—transactions, repo rates do not carry the same credit risk premium as LIBOR rates.

SOFR will be used in dollar-denominated credit facilities, but, as noted above, other markets have adopted or are expected to adopt their own Risk-Free Rates (RFRs) in place of LIBOR. For example, the Euro Short Term Rate (€STR) replaced the Euro Overnight Index Average (EONIA) at the start of 2022, and the Sterling Overnight Index Average (SONIA) has replaced GBP LIBOR.

Planning for the SOFR Future

As companies either prepare or continue to work through their LIBOR-SOFR transition, we recommend they keep three key steps in mind:

1. Review Lending Agreements

Every company should consider reviewing lending agreements to see whether lenders or suppliers used LIBOR as a rate-setting mechanism. You’ll want to obtain a clear view on all contractual terms, especially those regarding fallback provisions or the lack thereof, which can determine LIBOR exposure.

There is no doubt that the impact is widespread. The New York Fed estimated that even retail mortgage contracts referencing USD LIBOR are valued at $1.3 trillion, with more than $800 billion maturing after June 2023. Non-syndicated business loans also amount to $1.3 trillion, with $400 billion maturing after June 2023.

In many cases, there might be fallback terms that specify a replacement rate for LIBOR. If so, determine the likely impact of the terms shift and which party has the right to call the rate. If not, refer to recommended fallback terms (more on this below).

2. Review Reporting Systems

Conduct a comprehensive audit to determine the potential LIBOR impact on various internal programs and processes. Because LIBOR and SOFR have different characteristics, IT systems might need updates to manage financial products, such as loans, that reference interest compounded in arrears.

Additionally, look at your infrastructure to determine the potential impact on software systems. Engage with hardware and software vendors if necessary to facilitate the transition. These operational and IT impacts should also be incorporated into other related projects that may be interdependent.

For example, if your company is currently inputting LIBOR plus the spread into your accounting software, you will want to ensure it can accommodate SOFR as well. Similarly, if you use LIBOR as the basis for intracompany loans, you’ll need to update internal processes. Additionally, be prepared to incorporate SOFR into any LIBOR-based forecasting models your company uses today.

3. Create an Action Plan for the Transition

To prepare for the transition to SOFR and potentially other RFRs, establish a framework to inform key stakeholders of the overall impact, the game plan to make the required changes, and the progress to date. It’s also a good idea to share these with the board of directors and senior leadership to ensure appropriate governance during the transition and to consult corporate legal counsel when and if needed along the way.

Undoubtedly, senior leadership will be keen to understand the financial impacts of the transition. Estimating that can be challenging. As mentioned above, existing agreements, especially those predating LIBOR’s demise, may lack fallback language in the event LIBOR rates are unavailable. In those cases, you can refer to—or in some states, such as New York, you must refer to them by law—these recommended fallback provisions from the New York Fed.

For those agreements that do stipulate a fallback—perhaps a prime or base rate—the impact is more clearly defined and should be easier to model.

Plan Now with Trusted Partners

Each of these steps is critical to preparing for the post-LIBOR era. Much of the shift is unfolding in real time—SOFR is still catching on—but now is the time to plan for the impact.

It’s easier if you’re not managing the transition alone. Consider reaching out to trusted advisors for input and assistance, whether that’s your bank, auditor, lawyer, or M&A advisor. For many businesses, it’s the relationship manager at your financial institution who can be a crucial resource as you sort out your action plan.

Success will not come by chance. A deliberate, strategic approach to the transition will be necessary to limit disruptions and meet expectations. SOFR is here, and there’s little time left to waste.