One of the most complicated concepts facing many new and existing business owners is financing. Getting loans for your business, understanding basic concepts such as LIBOR, while standard practice and often necessary, can be confusing and difficult. Worse, if you don’t know how and why loans are issued and the differences between loaning practices, it can be even harder to find the right bank, and the right loan, for your business.
If you want to keep up to date with how loan standards are changing and what those changes mean for you and your business, keep reading.
What is LIBOR, and how is it used today?
LIBOR stands for London Interbank Offered Rate and is an interest rate index used for making adjustments to adjustable rate mortgages, business loans, and other tradable financial instruments. Its primary use is also as a benchmark interest rate that banks can use for loans to other banks.
If you’re thinking that this is a standard table of interest rates for different kinds of loans and loan terms, that’s not quite right.
Current LIBOR rates are published every day by the Intercontinental Exchange, or ICE. The published rate is calculated using the Waterfall methodology, which is a transaction-based and data-driven method.
However, because of problems with LIBOR rates in the past, and specifically with how LIBOR ultimately contributed to and worsened the 2008 financial crash, LIBOR is being phased out by June 2023.
Some LIBOR rates, including the one-week and two-month USD LIBOR rates, stopped being published back in December of 2021. However, since the interest rate banks used for lending to each other can also have a big impact on the other loans available, it’s important to understand why LIBOR was so popular in the first place as well as the key differences between LIBOR and SOFR, the replacement that will be active by July of this year.
Why is LIBOR popular for lending?
LIBOR was introduced as a means of determining interest rates. It’s basically a shared benchmark that banks could reference to see what a reasonable interest rate would be for different loans.
LIBOR uses a specific system to determine rates, which means that LIBOR rates don’t set the interest rates on loans, but they do help banks determine what is safe and reasonable.
LIBOR was first introduced in 1986 and originally only used USD, pound sterling, and yen included in the rate.
The purpose of the rate was to allow banks to make floating rate loans that protect against excessive interest exposure and also help banks make sure they aren’t over or undercharging customers.
The rate index was popular in part because it was standardized; the rates changed, but the means of determining the rate did not. And, since it was public to everyone who needed to make or receive loans, it also allowed banks to reliably predict what the interest rate would be if they took out a loan that same day.
However, while LIBOR is used widely by all banks, only a few banks have ever directly played a role or are considered for membership. The member banks contribute data to LIBOR, and the LIBOR rate is the result of a trimmed mean of all the transaction data submitted to the index. In this case, the highest and lowest quartile of the dataset are thrown out, and the remaining data is averaged to determine the rate.
LIBOR has also gone through changes before now, so switching from LIBOR or SOFR isn’t entirely unprecedented. For example, LIBOR switched from BBA LIBOR to ICE LIBOR when the Intercontinental Exchange took it over. New currencies have also been added or removed from the index. Another big shift happened when LIBOR stopped being the only rates index and other interest rate indexes were introduced.
LIBOR scandal
Perhaps most important in the history of LIBOR is the LIBOR scandal, in which panel banks, the banks that have membership and submit their transaction data to the index, were intentionally rigging the rate. While the scandal wasn’t discovered until 2012, evidence suggests that rate-rigging efforts actually date back to approximately 2003 and that LIBOR, and potentially the rate rigging itself, contributed to the problems in 2008.
Reasons for shifting from LIBOR to SOFR
There are a few key reasons why banks are switching from the LIBOR index to SOFR (Secured Overnight Financing Rate). SOFR is just one of many possible replacements, so it’s important to know why the industry has SOFR as the top contender to replace LIBOR.
For one thing, after looking at all the serious contenders for the next standard rate index, the Alternative Reference Rates Committee (AARC) recommended SOFR. The AARC is based in the United States and was created by the Federal Reserve Board and the Federal Reserve Bank of New York.
Since the United States and its regulatory agencies have a tremendous impact on wider global markets, it’s generally advantageous for international banks to use the same or a similar rate index as is standard practice in the United States.
One of the main reasons for the switch, beyond the LIBOR scandal lowering confidence in that rate, is that SOFR uses a larger dataset. That larger dataset helped to give the AARC confidence that SOFR would be effective in a wider range of market conditions than LIBOR was.
How SOFR is different from LIBOR
The main difference between LIBOR and SOFR is simpler than it might seem on the surface. Where LIBOR based its rates on panel bank inputs so only member banks had any power over the rate and only their customer’s transactions were counted, SOFR is broader.
SOFR uses the cost of borrowing cash overnight as collateralized by the U.S. Treasury in the repurchase agreement market. By looking at those transactions, SOFR winds up having roughly $1 trillion in daily transaction volume. That’s roughly double the transaction volume LIBOR worked with on average.
In addition, SOFR provides risk-free rates, which means that they don’t account for credit risk in the calculation. LIBOR did calculate for credit risk. SOFR is also secured with U.S. treasuries, while LIBOR is an unsecured interest rate index.
The last two big differences are that SOFR only includes USD, though it is possible that the index will expand to include other currencies in the future. Additionally, where LIBOR was designed to be forward looking, SOFR has a no-term structure, and because the data is collected overnight, it uses backward-looking data.
What does the shift from LIBOR to SOFR mean for markets?
There are a few important things to consider depending on what kind of business you’re running. Here’s what you need to know about what this shift does for you and your business.
Is the switch from LIBOR to SOFR only happening in the United States?
No. Global banks are all making this kind of switch, though not all banks are going to be using SOFR. Instead, banks are switching to rate indexes that use their currencies, but the switches are almost all to overnight and risk-free rates. So, while the index may be different, the results should be similar, and they should be using the same kind of data, if not the same datasets.
Does the shift from LIBOR to SOFR mean that my business loans will change?
Not necessarily. If you received your business loan after 2021, it’s likely that your bank may have already switched away from LIBOR in the creation of that loan and that they will have referenced a different (but specified) reference rate in the loan.
However, if you do have a loan that uses the LIBOR rate as its reference, your loan provider should give you the option to refinance your loan using the new SOFR rate.
Some banks may have used what’s called hardwired fallback language for their existing loans using LIBOR. That basically means that, included in the loan, they’ve provided a framework for transitioning the agreement after LIBOR is phased out at the end of June 2023. No additional changes to the loan should be necessary if this language is already in place.
Does changing from LIBOR to SOFR mean that loan payments will change?
Yes, though more in how floating-interest loan payments are calculated rather than the actual amounts.
The main reason for this is that under LIBOR, the rates at the beginning of the month determined what your payment for that month would be — or, if you had a three-month term, for the next three months. Then you’d make payment at the end of the month.
Under SOFR, rates are calculated every day based on overnight data. So, the calculation won’t actually be completed until the end of the month.
Again, though, since SOFR is specifically designed to be used with the derivatives market and is only one factor determining consumer and business loan rates, those loans should be more shielded from the change. Adjustable-rate mortgages, private student loans, and other debt instruments may see some impact and changes to the way the loans are written.
That said, lenders have literally had years to figure out what they need to do to smooth the transition between these two reference rates, so the actual impact on individual borrowers and businesses should be relatively small.
Is switching to SOFR going to cause market instability?
Some of the transition to SOFR has already happened as banks and financial institutions started the transition back in 2022 after LIBOR stopped releasing certain key rates in December 2021. So, while there is some volatility predicted to be associated with the transition to SOFR, at least some of that volatility has already happened and has been happening ever since the switch began.
That said, there is some trading volatility, specifically in the derivatives market. For most people, so long as volatility is controlled, there shouldn’t be a major market impact from the switch.
At the same time, since other places are looking to alternative rates that use their currencies, like SONIA in the U.K. and EONIA in the European Union, there may be more differences between national and international bank rates than there used to be.
Not that all banks used LIBOR or used LIBOR exclusively, but this switch is prompting the creation and adoption of a wider range of interest rate indexes.
What you need to do to prepare for the transition from LIBOR to SOFR
There are a few things you can do to help your business be ready for the transition.
On the most basic level, you should stay aware of the transition and pay attention to upcoming transition milestones and when specific changes are going to happen. That way, you can work with your bank and plan for any changes to your loans or assets in the meantime.
You should also look at your existing loans and, specifically, for the LIBOR provisions, so you are familiar with any existing language about the transition. In fact, often the language included in your LIBOR may answer the key questions you might have.
You should also consult with any professional or financial advisors you already work with on the transition, including learning about any differences between LIBOR and SOFR calculations that would be relevant to your business.
Lastly, keep an eye on internal systems, including your liquidity and ability to pay loans at alternative rates, so that you’re prepared for any changes in your payments. Your accounting and tax programs may also have tools that can help you assess any changes in the transition as well.
For the average business owner, this change shouldn’t be too significant, but if you work with derivatives or have multiple loans, you may see more impact than most.
Stay on top of the business and finance information you need
Starting your own business is already a huge undertaking. Keeping track of everything you need to know to manage that business, on top of dealing with day-to-day management concerns, can be a daunting task.
Fortunately, SRSR is here to help you find out what you need to know when you need to know it and to give you the tips, tricks, and business savvy you need to make your business a long-term success. Keep an eye on our site for updates, informational articles, and more.