AFS Survey Results on Bank Preparations for LIBOR Replacement

AFS Survey Results on Bank Preparations for LIBOR Replacement January 2018 Value Solutions Responsibilities

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Table of Contents Background... 4 So What is SOFR?... 5 Notable Differences Between SOFR and LIBOR... 6 U.S. Commercial Loan Dependence on LIBOR... 6 Impact on Credit Agreements... 8 AFS Survey Results... 9 Summary of Responses and Key Takeaways... 9 Individual Bank Responses... 10 3

AFS Survey Results on Bank Preparations for LIBOR Replacement and State of Credit Agreements Background In today s expansive financial markets, a significant number of diverse asset classes rely on LIBOR to set interest rates and values. By some estimates, over $150 trillion in financial market instruments are tied to LIBOR in some form or fashion. While derivatives have by far the highest exposure, estimates for loan exposure tied to LIBOR (primarily syndicated loans but also other Corporate business and Commercial Real Estate loans) are also significant exceeding $4 trillion by some estimates. During the financial crisis, reports began to surface that employees at several major banks had manipulated LIBOR by altering the quotes they submitted for use in its calculation. Global regulatory agencies gradually uncovered and prosecuted several cases of LIBOR manipulation, resulting in billions of dollars in fines and related enforcement actions, both individual and institutional. With market confidence in LIBOR rate setting and governance waning, regulators stepped up their review. Initial efforts focused on strengthening LIBOR oversight, but in their work regulators began to not only see governance issues but also a long standing market benchmark that was actually supported by far too few actual market transactions. For example, it is now estimated that greater than 70% of three month LIBOR submissions are based on the estimates of the submitting banks, not actual transactions. This led regulators and other interested stakeholders to conclude that the market for unsecured wholesale term lending to banks is no longer sufficiently active from which to derive reliable benchmarks. Add in the fact that the LIBORsubmitting banks were facing increasing liability even for those who had not been accused of any wrongdoing and a compelling case was developing for finding an alternative reference rate to LIBOR. Since the scandal unfolded, central banks around the world have been scrambling to develop alternatives to LIBOR. In the U.S., a group called the Alternative Reference Rates Committee, or ARRC, has been leading efforts to identify an alternative to U.S. Dollar LIBOR. In June 2017 the ARRC announced their preferred rate, something called the Secured Overnight Financing Rate or SOFR. The Federal Reserve then conducting a public comment period, and on December 8, 2017 announced final plans for the production of SOFR and two other new reference rates to begin in the second quarter of 2018 (see table of Timeline of Key Events). 4

So What is SOFR? SOFR will provide a broad measure of the general cost of financing Treasury securities overnight. SOFR will include triparty repo data from Bank of New York Mellon (BNYM) and cleared bilateral and GCF Repo data from the Depository Trust & Clearing Corporation (DTCC). SOFR will be calculated as a volume weighted median transaction rate. Most importantly, the daily market transactions underlying SOFR average over $750 billion, exponentially more robust than average daily volumes for U.S. dollar unsecured funding markets. Importantly, the Federal Reserve has never stated that institutions under their jurisdiction can no longer use LIBOR. Nor have they stated that institutions must transition to SOFR. Rather, the Fed s designated committee the ARRC after much research, deliberation, and public comment has selected SOFR as its recommended alternative to U.S. Dollar LIBOR. Whether or not market participants choose to use SOFR or some other reference rate is something that will continue to play out in the months and years to come. Timeline of Key Events November 17, 2014 Federal Reserve convenes meeting with major market and official sector participants to discuss the process for developing risk free reference rate alternatives to LIBOR. This meeting led to the formation of the Alternative Reference Rates Committee (ARRC), who was charged with (a) identifying a robust alternative to U.S. dollar LIBOR and b) developing a transition plan. June 2017 ARRC announces its preferred reference rate, initially called the Broad Treasuries Financing Rate (BTFR) and later changed to Secured Overnight Financing Rate (SOFR). July 27, 2017 Speech by Andrew Bailey, Chief Executive of U.K. s Financial Conduct Authority (FCA) notes the absence of active underlying markets means the future sustainability of LIBOR could not be guaranteed; announces the FCA would not require banks to submit information for LIBOR after 2021. August 24, 2017 Federal Reserve requests public comment on a proposal to produce three new reference rates based on overnight repo transactions secured by Treasuries. November 24, 2017 The FCA announces that all banks that participate in LIBOR rate setting had agreed to continue to voluntarily submit LIBOR quotes through 2021 to facilitate an orderly transition away from LIBOR. November 27, 2017 ARRC announces it will be reconstituted in 2018 in order to more directly facilitate issues of legacy contract robustness and transition for cash products as well as derivatives. December 8, 2017 Fed announces final plans for the production of three new reference rates based on overnight repurchase agreement (repo) transactions secured by Treasury securities. The Fed said they expect to begin publishing rates in the second quarter of 2018, daily at 8 a.m. EST. The New York Fed and the Office of Financial Research will prepare the rates. 5

Notable Differences Between SOFR and LIBOR One notable weakness to the proposed SOFR is there is no term structure SOFR is an overnight rate. LIBOR, on the other hand, is available in seven different maturities. The ARRC recognizes this and is working on plans to create a term structure for SOFR. For example, a term reference rate could conceivably be developed by first developing futures and Overnight Index Swap (OIS) markets that reference SOFR. Another perceived weakness to SOFR compared to LIBOR is lack of a baked in premium for credit risk. Because SOFR is to be based on transactions secured by Treasury securities, it is essentially a risk free rate. Bank credit risk is not captured, unlike LIBOR. LIBOR is also published in five different currencies today. This presents a risk for fragmented reference rates for multicurrency loans, as other central banks around the world have either selected or are exploring alternative rates as well. Significant international market coordination work remains to ensure approaches and methodologies are transparent and ensure multicurrency loan facilities remain attractive and viable. U.S. Commercial Loan Dependence on LIBOR While the most obvious segment dependence on LIBOR is the syndicated market, a significant and growing percentage of the bilateral market is tied to LIBOR as well. Figure 1 displays the percentage of commercial loan outstandings and their interest rate indices, which are primarily U.S. Dollar LIBOR, U.S. Prime, or Fixed. The chart on the left in Figure 1 shows this distribution first for all loans, then segregates them into bilateral loans versus loans that are part of a syndication or participation arrangement. Here we see that 95.2% of the participations /syndications are tied to U.S. Dollar LIBOR, as one might expect. However, 62% of the bilateral loans are also tied to U.S. Dollar LIBOR, which suggests that the challenges associated with replacing U.S. Dollar LIBOR are not just limited to the banks that are heavily involved in syndicated lending. The chart on the right hand side of Figure 1 on the next page illustrates a similar distribution, but only for the new and renewed loan volume, defined as activity within the last three month period. For the recent new and renewed deals, the use of Prime has increased slightly for the participation and syndication group, while the use of U.S. Dollar LIBOR has increased modestly for the bilateral loans (64%). 6

Percent of Total Loan Outstandings Percent of New/Renewed Loan Volume 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 19.1% 5.9% 72.1% 26.9% 7.3% 62.1% 95.2% All Loan Types Bilateral Loans Participations/ Syndications 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 8.4% 14.4% 73.0% 5.8% 11.5% 18.4% 64.3% 6.5% 90.2% All Loan Types Bilateral Loans Participations/ Syndications LIBOR Prime Fixed Other LIBOR Prime Fixed Other Figure 1 Source: AFS Data In Figure 2 we contrast the use of U.S. Dollar LIBOR and other indices by deal size, first for the bilateral loans on the left then the participation and syndication group on the right. Predictably, U.S. Dollar LIBOR is the dominant index for the participation/syndication group on the right, regardless of the size of the deal. For the bilateral loans, the use of U.S. Dollar LIBOR is greater as deal size increases, and exceeds 70% of loans on an exposure basis for loans greater than $10 million and Commercial Real Estate loans. And while the use of U.S. Dollar LIBOR for smaller bilateral loans (< $3 million) is less, it is still the prevailing index for nearly one third of outstanding balances. Percent of Total Loan Outstandings Bilateral Loans Percent of Total Loan Outstandings Participations/Syndications 100% 100% 90% 80% 70% 60% 26.5% 7.3% 46.2% 24.9% 6.9% 19.3% 5.5% 20.8% 90% 80% 70% 60% 9.2% 50% 40% 30% 62.3% 17.7% 65.2% 72.7% 71.5% 50% 40% 30% 95.2% 84.8% 92.6% 96.6% 97.5% 20% 10% 32.3% 20% 10% 0% All Loan Sizes/Types <$3M $3M<$10M >=$10M CRE 0% All Loan Sizes/Types <$3M $3M<$10M >=$10M CRE LIBOR Prime Fixed Other LIBOR Prime Fixed Other Figure 2 Source: AFS Data 7

Figure 3 illustrates commercial loan exposure by term to maturity for both bilateral and syndicated U.S. Dollar LIBOR rate corporate loans. The vast majority of the participation/syndicated loans have stated maturities inside of five years. And while 30% of the bilateral loans mature in under a year, nearly 10% of the bilateral loans tied to LIBOR don t mature for another ten years, and will have to have their credit agreements modified or otherwise amended. 35% 30% 25% Exposure Distribution by Term to Maturity LIBOR Rate Corporate Loans Bilateral Loans Participations/Syndications % Exposure 20% 15% 10% 5% 0% Term to Maturity Range Figure 3 Source: AFS Data Impact on Credit Agreements Some syndicated loan credit agreements provide fallback language in the event LIBOR is unavailable. That said, lenders have expressed concern that fallback language was designed for only temporary market disruptions, not something like the potential discontinuation of LIBOR altogether. In many cases banks will have to develop new language for new credit facilities and modify existing contracts for existing loans. While the ARRC has proposed a path forward, a transition will take time and is not without risks. One thing banks can do now is research their own unique fallback language and any ability to amend contractual language should LIBOR be discontinued. 8

It is very likely that in the event that LIBOR ceases to be published beyond 2021, there will still be many outstanding loans and corresponding credit agreements that will not have a legal mechanism to substitute an alternative reference rate for LIBOR. Additionally, given the absence today of a published replacement rate (SOFR is not scheduled to begin to be reported until the second quarter of 2018), LIBOR legacy loans will, in all likelihood, continue to be underwritten without sufficient replacement rate language. Both of these facts could present risks to banks and create further market dislocation as the various financial markets and asset classes transition away from LIBOR. AFS Survey Results In order to get a sense of activity and general awareness in the market, AFS conducted a brief survey on the topic of U.S. Dollar LIBOR replacement, focused primarily on what individual bank efforts are underway to replace or update credit agreement language to address a future without LIBOR. Banks were posed the following questions: 1. Given the fact that efforts are underway to replace LIBOR as a primary reference rate, has your bank changed their underwriting documentation in any material way to account for this uncertainty post 2021? 2. Do your current standard credit documents make any mention or provide a clause for the possibility that LIBOR could become permanently unavailable, and provide for a change to an alternative reference rate? Summary of Responses and Key Takeaways While the vast majority of large syndicated credits are tied to U.S. Dollar LIBOR, a meaningful amount of smaller, middle market borrowers prefer U.S. Dollar LIBOR as a base rate in their credit agreements. While some banks reported having adequate replacement rate language in current credit agreements, several banks have yet to make any changes. Some banks have been having active discussions, looking at alternatives and following the work of the ARRC, while some have not actively engaged in transitioning away from U.S. Dollar LIBOR. Some banks report customers have begun asking about changes from U.S. Dollar LIBOR. 9

Individual Bank Responses Categorization [Bank Total Assets] Commercial Mix* [Fixed LIBOR Prime] Avg. TTM of LIBOR loans* (years) Response/Comments Large (>$100B) 40% 51% 5% n/a It is less relevant to us on the low end of the spectrum since we are currently using Prime as our primary variable rate index on our smaller business clients. Our partners in larger business lending segments may have a different perspective. Mid size superregional (<$100B) Mid size superregional (<$100B) 33% 57% 5% 3.44 On the small lending side, we are principally pricing against U.S. indexes. It s not on the larger commercial lending radar yet. My Legal Department responded that the current loan document does have language already to allow resetting with a different index. It was not created for the LIBOR issue, it was already part of the loan docs. 15% 83% 2% 2.86 New language has been developed in conjunction with internal legal that addresses this. It is just now beginning to be used. The issue had to be addressed as we were seeing this come up in the market and with other banks. Regional (<$50B) n/a n/a The first thing we did was check our loan documentation, and we re satisfied that we have sufficient language to allow us to change the rate once LIBOR is discontinued. That s for both legally prepared documents as well as those generated by LaserPro. Mid size superregional (<$100B) 7% 89% 3% 2.76 This issue has not been a major focus in our bank as yet. Large (>$100B) 21% 75% 4% 3.07 That language has been in place for years and preexisted any conversation about LIBOR going away. Large (>$100B) 14% 82% 4% 9.27 For retail mortgages, there s the ARRC which has been working on this for some time and recommends the overnight treasury repo rate called SOFR. I suspect we will follow what they decide on as we would probably spend too much time defending an alternative decision. But we are still somewhat early in the process so we ll see where it goes. From a customer and loan docs perspective, we can switch to a comparable rate. That s standard mortgage note language and it should be somewhat seamless. The residential division has the biggest impacts but the docs should let us make the change with hopefully little to no customer impact. Messaging will be the key so as to not set off a panic. I suspect most customers will not be too concerned. 10

Categorization [Bank Total Assets] Commercial Mix* [Fixed LIBOR Prime] Avg. TTM of LIBOR loans* (years) Response/Comments Large (>$100B) 21% 73% 5% 2.77 Not yet but I know it s a big topic with a lot of important people. Large (>$100B) 16% 78% 3% 4.00 Our standard loan documents have always had a clause to handle a LIBOR goes away/becomes unusable scenario. The replacement rate in our shelf documents is the higher of a Fed Fundsbased or Prime based formula. It is a clause that historically does not get negotiated since the market has generally viewed this as a never going to happen situation. With the LIBOR issue now getting some real press, some borrowers are examining the clause and attempting to negotiate it. We have been willing to adjust the standard replacement formula to a more balanced conversion although it remains tied to either Fed Funds or Prime. We have also, on occasion, inserted a clause that references the possibility of moving to the new ARRC rate, at OUR option if appropriate. At this point, we are unwilling to commit to an ARRC recommendation, sight unseen, even though most everyone believes that the ARRC will eventually figure out a fair, balanced and market acceptable alternative structure and conversion. Large (>$100B) n/a n/a No, we haven't changed anything. I think most banks, like us, are waiting to see the new reference rate which is due out in Q2. Large (>$100B) 31% 59% 6% n/a At some point, we, and banks in general, will need to deal with this, however as of now nothing is happening here. *Based on AFS data 11