This letter provides guidance on the discontinuance of the London Inter-Bank Offered Rate (LIBOR) that will assist examiners’ assessment of a credit union’s preparations in transitioning away from LIBOR to an alternative reference rate or rates. The NCUA Board identified the LIBOR Transition as a primary area of supervisory focus in the NCUA Letter to Credit Unions 21-CU-02, NCUA’s 2021 Supervisory Priorities.
While some smaller and less-complex institutions may have limited exposure to LIBOR-indexed instruments, the transition to alternative reference rates will affect almost every financial institution. Additionally, as described in NCUA Letter to Credit Unions 21-CU-03, LIBOR Transition, the revised final date of June 30, 2023 to stop publishing the more widely used LIBOR settings does not suggest transition preparation is less urgent. U.S. financial institution regulators, including the NCUA, strongly advise that institutions stop using LIBOR in new financial contracts as soon as possible, but no later than December 31, 2021.
LIBOR is a widely used short-term interest rate benchmark referenced in derivative, bond, and loan contracts, including a range of consumer lending instruments such as mortgages and student loans. The current U.S. dollar (USD) LIBOR settings include overnight, one-week, one-, two-, three-, six-, and twelve-month rates.
In July 2017, the United Kingdom Financial Conduct Authority (FCA) announced it would stop requiring banks to submit the information necessary to calculate LIBOR rates after December 31, 2021. Since then, the FCA and other regulatory bodies strongly advised (opens new window) all LIBOR users to transition away from LIBOR-indexed transactions by December 31, 2021.1 A July 2020 Federal Financial Institutions Examination Council Joint Statement on Managing the LIBOR Transition (opens new window) highlighted the risks that will result from the transition away from LIBOR. U.S. banking regulators, including the NCUA, advised that new financial contracts should avoid using LIBOR no later than December 31, 2021.2
A clearer transition path away from LIBOR began to develop in November 2020, when LIBOR’s authorized and regulated administrator, Intercontinental Exchange Benchmark Administration (IBA), began to evaluate whether to continue publishing specific USD LIBOR settings after December 31, 2021.3 On March 5, 2021, the IBA stated (opens new window) it would stop publishing the one-week and two-month USD LIBOR after December 31, 2021, and the remaining USD LIBOR settings, including the one-, three-, six-, and twelve-month settings, after June 30, 2023.4 The extension until June 30, 2023, allows existing transactions that are indexed to the more widely-used LIBOR settings to mature naturally.
Given consumer protection, litigation, and reputation risks, the NCUA believes that entering new contracts using LIBOR as a reference rate after December 31, 2021, would create safety and soundness, and compliance risks.
The NCUA encourages federally insured credit unions (FICUs) to stop entering new contracts that use LIBOR as a reference rate as soon as possible. New contracts entered into before and after December 31, 2021, should use a reference rate other than LIBOR or have robust fallback language (opens new window) that includes a clearly defined alternative reference rate. Along with a successor rate, robust fallback language also involves specifying a set of triggers, a spread adjustment, and some description of the conforming changes that are necessary.
II. Potential LIBOR Exposure
As discussed above, credit unions use LIBOR in a variety of products, including derivatives, business loans, consumer loans, variable rate notes, and securitizations, such as mortgage-backed securities. Credit unions may have LIBOR exposure in these types of transactions as well as Federal Home Loan Bank (FHLB) borrowings and various other member share products that use a variable interest rate. Although credit unions typically have limited LIBOR exposure, the following are some examples in which LIBOR may be present and prompt an examiner to review for material risk.
Real Estate Loans
The most common member service product that has traditionally used LIBOR as a reference rate is the adjustable-rate mortgage (ARM). Credit unions could originate an ARM using loan underwriting standards established by a government-sponsored enterprise (GSE) such as Fannie Mae or Freddie Mac. The GSEs also provide fallback language that describes the steps that will be taken if LIBOR is no longer available, and how a replacement index will be substituted under a variety of circumstances. Additionally, Fannie Mae and Freddie Mac stopped acquiring single-family and multifamily LIBOR ARMs on December 31, 2020. ARM mortgages that conform to GSE underwriting standards that credit unions originate represent low LIBOR transition risk exposure.
For non-conforming or customized ARMs that a credit union has originated and held in its portfolio, examiners should determine if an ARM has robust fallback language in the event the variable rate index is no longer available.
Student loans also make up a significant portion of LIBOR-indexed loans owned by credit unions. Given the potential for a high number of individual student loan accounts and the likelihood of frequent instances of address/employment changes, student loans may present difficulties in communicating loan rate changes to a borrower. If a credit union holds a significant number of LIBOR-indexed student loan accounts, examiners may consider reviewing the credit union’s transition plan, check for fallback language, and determine if the credit union has dedicated sufficient resources to modify LIBOR-indexed student loan accounts.
Credit unions will typically have limited LIBOR exposure in commercial loan portfolios. A commercial loan may be part of a syndicated loan—typically, a variable rate instrument that references LIBOR as the variable rate index. Variable rate commercial loans originated by a credit union are generally indexed to the Prime rate.
Auto loans typically use a fixed interest rate due to the relatively short-term maturity of the loans.
Credit card loans are revolving lines of credit with no fixed maturity date and are typically variable in rate using the Prime rate as a base index, plus an added spread to account for credit risk.
While the GSEs stopped issuing new LIBOR-indexed securities as of December 31, 2020, the legacy LIBOR-indexed securities remain a significant percentage of variable rate assets held by credit unions. Fortunately, LIBOR-indexed investments typically have bond trustees that represent investors who are responsible for implementing robust fallback language to a new reference rate or rates in the transition away from LIBOR, which allows examiners to review such holdings with a low level of concern.
As of September 27, 2019, the Federal Housing Finance Administration directed the FHLBank System (opens new window)5 to stop entering into LIBOR-based transactions that involve advances with terms that mature after December 31, 2021.6 In July 2020, member banks in the FHLBank System asked members to specifically identify LIBOR-indexed loans that are listed as collateral.7 Examiners may want to determine if the amount of LIBOR-indexed real estate loans pledged as collateral to a FHLB are material, given the state of readiness of the credit union’s transition planning.8
Dividend rates paid on share accounts that include money market, regular shares, and share drafts are set by the credit union’s board of directors, thereby providing a credit union with broad flexibility in setting share rates. As with other share accounts, including term share certificates, examiners should understand the rate-setting methodology implemented by the credit union and determine if any indexes used to reprice share accounts are LIBOR-based.
While interest rate derivatives are by far the largest transaction exposure to LIBOR transition risk for financial institutions, this exposure is significantly smaller in the credit union industry. Interest rate swaps are the most common type of derivative that references USD LIBOR. Interest rate swaps involve the exchange of a fixed interest rate for a variable rate, or vice versa,and where the variable rate in the swap is often LIBOR.
Derivative transactions are governed under an International Swaps and Derivatives Association (ISDA (opens new window)) agreement. In October 2020, ISDA launched its Fallbacks Supplement (opens new window) and Fallbacks Protocol (opens new window), which amend ISDA’s standard definition for interest rate derivatives to incorporate robust fallbacks for derivatives linked to a key interbank offered rate.9 These changes became effective January 25, 2021. Swaps that are centrally cleared can be considered low risk, as can bilateral swaps for which counterparties have signed the ISDA protocol.
III. LIBOR Replacement Alternatives
The NCUA does not endorse a specific replacement rate for USD LIBOR. A credit union may use a reference rate for its loans and member shares that it determines is appropriate for its risk management and member needs. All LIBOR-based contracts that mature after December 31, 2021 (one-week and two-month) and June 30, 2023 (one-, three-, six- and twelve-month) should include contractual language that provides for use of a robust fallback rate.10
Secured Overnight Financing Rate
In response to the USD LIBOR replacement initiative, the Federal Reserve Board of Governors convened the Alternative Reference Rates Committee (ARRC) in cooperation with the U.S. Department of Treasury, the U.S. Commodity Futures Trading Commission, and the Office of Financial Research, in 2014 to identify and promote robust alternatives to the USD LIBOR.
In June 2017, the ARRC selected the Secured Overnight Financing Rate (opens new window) (SOFR) as its recommended alternative to the USD LIBOR.11 The SOFR is a broad Treasuries repurchase financing rate and has been produced by the Federal Reserve Bank of New York on a daily basis since the second quarter of 2018. The SOFR is based on transactions in the Treasury repurchase market, where banks and investors borrow or loan Treasuries overnight. As a result, SOFR is a secured rate and does not have a credit risk element.
Additionally, some financial contracts referencing LIBOR do not envision a permanent or indefinite discontinuance of LIBOR. Existing contracts, therefore, either do not have fallback language that adequately addresses a permanent LIBOR discontinuance or have language that could dramatically alter the economics of contract terms if LIBOR is discontinued. Although most existing contracts may be amended, the amendment process might be challenging, if not impossible, for certain products.
While a substantial number of financial contracts that reference USD LIBOR are governed by New York law, New York State passed legislation in April 2021 to minimize the legal uncertainty and adverse economic impact associated with the LIBOR transition. The legislation addresses legacy contracts that mature after June 2023 and do not have effective fallbacks by:12
- Prohibiting a party from refusing to perform its contractual obligations or declaring a breach of contract as a result of the discontinuance of LIBOR or the use of the statute’s recommended benchmark replacement;
- Definitively establishing that the recommended benchmark replacement is a commercially reasonable substitute for and a commercially substantial equivalent to LIBOR; and
- Providing a safe harbor from litigation for the use of the recommended benchmark replacement.
IV. Examination Considerations
Examiners should review credit union planning for the transition away from LIBOR during examinations and supervision in 2021. They should tailor their review to the size and complexity of a credit union’s LIBOR exposures. For most credit unions, exposure to LIBOR is modest. Reviews should be narrowly focused and the seven review areas described below should be considered as a guide when planning examination work.
Examiners should document their findings relative to LIBOR exposure and preparedness in the revised LIBOR Alternative Readiness Workbook and communicate any findings and recommendations to the credit union’s board and management through the examination report.
LIBOR Transition Review Scope
Examiners will determine if the LIBOR risk exposures to a credit union are minimal using the following criteria:
- Credit union is prepared to stop originating or engaging in any LIBOR-related transactions as soon as possible, but not later than December 31, 2021.
- Credit union has minimal exposure to one-week or two-month LIBOR-indexed transactions that mature after December 31, 2021 (either by the total number or dollar balance) that do not have robust fallback language.
- Credit union has minimal exposure to one-, three-, six-, and twelve-month LIBOR-indexed transactions that mature after June 30, 2023 (either by the total number or dollar balance) that do not have robust fallback language.
If a review is necessary, examiners should review the credit union’s LIBOR transition activities to assess whether they adequately address the key areas discussed in detail below.
A. Transition Planning
Credit unions should plan to transition away from using LIBOR in any new transactions by December 31, 2021. The detail and scope of transition plans, along with regular status updates, should be commensurate with LIBOR exposures and shared with applicable management and board committees. Credit unions that have complex products or multiple product lines tied to LIBOR should maintain detailed plans and a project roadmap that defines transition timelines and milestones.
B. Financial Exposure Measurement and Risk Assessment
FICUs with financial exposure to LIBOR should accurately measure and report their exposure to senior management, and the board or board committees when warranted. The exposure reporting should include product details for the number of and total balance of contracts and the costs associated with transitioning away from LIBOR.
C. Operational Preparedness and Risk Control
FICUs should identify any internal and vendor-provided systems and models that use or require LIBOR as an input and, if possible, remediate those systems and models ahead of the respective LIBOR discontinuance date. The credit union should establish a contingency plan in the event a service provider is unable to deliver a timely solution.
D. Contract Preparedness
FICUs with exposure to LIBOR should identify contracts that reference LIBOR and cease from entering into new contracts without fallback language. Fallback language refers to contractual provisions that lay out the process through which a replacement rate can be identified if a benchmark (for example, LIBOR) currently referenced by the contract becomes unavailable. A credit union’s transition plans should address how management will determine the impact of LIBOR’s discontinuation on its contracts and the steps the credit union will take to modify these contracts prior to LIBOR’s discontinuance.
Commensurate with their exposure to LIBOR, FICUs should communicate the implications of the LIBOR transition on impacted financial products to their counterparties and members. FICUs should comply with requirements of the Truth in Lending Act (opens new window) and other applicable laws and regulations and with the prohibition on engaging in unfair, deceptive, or abusive acts and practices. For more information, see the NCUA’s Federal Consumer Financial Protection Guide.
A credit union should provide its transition plan to the personnel necessary to implement the transition and provide regular status updates to senior management and the board.
Examiners should review management’s plan to determine if a credit union is able to identify and understand its LIBOR exposures. Additionally, examiners should discuss LIBOR exposures with management and evaluate whether the credit union has an established plan to transition away from entering into any new LIBOR-based financial contracts before December 31, 2021. This will ensure that any exposures to the respective LIBOR setting discontinuance dates are identified and managed.
Please direct questions on the information presented in this letter to your immediate supervisor or regional management.
Office of Examination & Insurance
1 See FCA “Transition from LIBOR” last published March 26, 2021.
2 See Financial Regulators Issue Statement on Managing the LIBOR Transition (opens new window) issued by the Federal Financial Institutions Examination Council on July 1, 2020.
5 See FHFA Supervisory Letter – Planning for LIBOR Phase-Out dated September 27, 2019.
6 The FHLBank System was created by the Federal Home Loan Bank Act of 1932 as a GSE to support mortgage lending and community investment. It is composed of 11 regional banks which are privately capitalized and owned as cooperatives by their members. For more information, visit the FHLBanks website (opens new window).
7 In 2020, the various FHLBs began amending their collateral reporting requirements for LIBOR-based loans. For more information, examiners should check the credit union’s FHLB member website for LIBOR transition updates.
8 In May 2019, the member banks of the FHLBank System provided their members with regulatory expectations regarding the essential elements of a LIBOR transition plan. For more information, examiners should check the credit union’s FHLB member website for LIBOR transition guidance.
10 See Statement on Reference Rates for Loans (opens new window) dated November 6, 2020.
11 The ARRC selected the SOFR over the Overnight Bank Funding Rate, an unsecured overnight rate.
12 It should be noted that the New York LIBOR legislation does not affect contracts governed by jurisdictions other than New York, and that the parties to a contract governed by New York law remain free to agree to a fallback rate that is not based on USD LIBOR or SOFR. The new law does not override a fallback to a non-USD LIBOR based rate (e.g., the Prime rate) agreed to by the parties to a contract. Although this legislation provides crucial safeguards, it should not be viewed as a substitute for amending legacy USD LIBOR contracts where possible. Rather, it should be viewed as a backstop in the event that counterparties are unwilling or unable to agree to adequate fallback language prior to the cessation date or date of non-representativeness.