LIBOR TRANSITION UPDATE: FINANCIAL INSTITUTIONS BRACE FOR EXAM SCRUTINY

On March 9, 2021, the Federal Reserve Board published a Supervision and Regulation Letter (SR 21-7) (the “SR Letter”) containing guidance for examiners in assessing supervised firms’ LIBOR transition progress. Significantly, the SR Letter directs examiners to consider issuing supervisory findings and other supervisory actions for firms that are not prepared to stop using LIBOR by December 31, 2021.

The SR Letter follows the issuance of an Interagency Statement on LIBOR Transition on November 30, 2020, which noted that entering into new contracts that reference LIBOR after December 31, 2021 would create safety and soundness risks. The guidance also follows statements last week by the U.K. Financial Conduct Authority, the ICE Benchmark Administration Limited, the International Swaps and Derivatives Association (ISDA), and the Alternative Reference Rates Committee regarding the cessation of LIBOR.

The SR Letter covers examiner guidance for assessing LIBOR transition efforts at two groupings of supervised firms (e.g., bank holding companies, savings and loan holding companies, U.S. branches and agencies of foreign banks, and state member banks):

• Large Firm Guidance – supervised firms with $100 billion or more in total consolidated assets (including foreign banking organizations with consolidated U.S. assets of $100 billion or more), and

• Small Firm Guidance – supervised firms with less than $100 billion or more in total consolidated assets (including foreign banking organizations with consolidated U.S. assets of less than $100 billion).

All firms are required to plan to transition away from LIBOR. Both sets of guidance cover six areas of the LIBOR transition: (i) transition planning; (ii) financial exposure measurement and risk assessment; (iii) operational preparedness and controls; (iv) legal contract preparedness; (v) communication; and (vi) oversight. As the large firm guidance is distinctly more prescriptive than the small firm guidance, we summarize the notable features of the large firm guidance below. Although not specifically applicable to them, small firms may also find the large firm guidance helpful in preparing or evaluating their LIBOR transition plans.

Notable Features of the Fed’s Exam Guidance

Examiners are instructed to summarize findings and recommendations on LIBOR preparedness in examination reports and, if necessary, conduct additional targeted reviews for lagging firms before the end of 2021. In particular, examiners will focus on the following areas:

• Transition Planning – Examiners will look to whether a firm has a governance structure that clearly defines roles and responsibilities and a project roadmap with defined timelines and milestones. In addition, senior leadership of a firm is expected to provide appropriate budget and personnel resources to support transition preparedness.
• Financial Exposure Measurement and Risk Management – A firm should accurately measure its financial exposures to LIBOR, including any financial product that references LIBOR such as investments, derivatives, and loans. Exposures should be identified by product, counterparty, and business line, and whether exposures are proprietary or custodial. In particular, the firm should be able to identify the proportion of its LIBOR exposure that will run off before the relevant tenor ceases (December 31, 2021 or June 30, 2023, as applicable) and highlight valuation and hedging challenges resulting from switching from LIBOR to an alternative rate. In addition, foreign firms should measure LIBOR exposures booked and/or managed within U.S. operations, and quantify exposures within the U.S. operations in comparison to the LIBOR exposure of the consolidated foreign parent.
• Operational and Vendor Matters – The firm should identify all internal and vendor-provided systems and models that use or require LIBOR as an input and make any required adjustments to facilitate smooth operation of such systems and models ahead of cessation of LIBOR. In particular, the firm should confirm with its service providers that necessary updates will be available for testing and implementation before December 31, 2021 and establish a contingency plan if a service provider is unable to deliver a timely solution. Changes to firm models should adhere to sound model risk management practices as described in SR Letter 11-7, and progress reporting should be included in the firm’s transition plan.
• Legal Contract Preparedness – The firm should identify all contracts that reference LIBOR and refrain from entering into contracts without fallback language. For contracts that lack adequate fallback language and will mature after the relevant tenor ceases (December 31, 2021 or June 30, 2023, as applicable), the firm’s transition project plans should address how it will determine the impact of LIBOR’s cessation on these contracts and the steps the firm will take to address these contracts prior to LIBOR’s cessation. The firm should show progress in developing its plans and should have complete plans well before the cessation date of any particular tenor. For a firm that is a “major user of derivatives,” it should consider adhering to the ISDA IBOR Fallback Protocol and IBOR Fallback Supplement (together, the “Protocol”) to implement robust fallbacks for legacy and new derivative contracts. Customers who will not adopt the Protocol should be identified and actions should be taken to mitigate associated risks. In addition, new LIBOR-based contracts entered into before December 31, 2021 should have robust fallback language that includes a clearly defined alternative reference rate after LIBOR is no longer available. Firms involved in syndicated loans should consult their relevant agent banks to ensure that the agent banks are appropriately addressing fallback language in syndicated loan contracts.
• Communications – The firm should communicate about the LIBOR transition to its counterparties, clients, consumers, and internal stakeholders, and ensure compliance with requirements of applicable regulations (in particular, the guidance cites compliance with the Truth in Lending Act and prohibitions against unfair or deceptive acts or practices). The firm should train its employees with respect to the LIBOR transition, how it will affect staff work, and, if applicable, how staff are to communicate the implications of the LIBOR transition externally. A firm should also provide “regular updates” to key stakeholders.
• Oversight – The group designated by the firm to oversee its LIBOR transition plan should ensure timely updates to senior management and the board of directors. In addition, the group should regularly update senior management and the board on plan progress and provide alerts regarding any significant/material delays in plan progress. If the firm is a foreign entity with U.S. total assets over $100 billion, the firm should provide updates to its U.S. Chief Risk Officer and the U.S. Risk Committee. The board should hold senior management “accountable” for effectively implementing the firm’s plan.

The Gist: Get Ready for LIBOR Exam Scrutiny

The SR Letter sets out a clear path for both examiners and the firms subject to examinations with respect to LIBOR transition readiness. Firms considering their LIBOR transition plans should ensure adequate attention and resources are allocated in order to properly design, implement, and execute on such plans.

* * *

Please feel free to reach out to us with any questions on this SR Letter, the guidance set forth within, or any specific questions related to your LIBOR transition plan.