Regulators must provide relief during transition from Libor

Now that 2021 is over, regulators expect financial institutions to forgo use of the London interbank offered rate as a benchmark interest rate to gauge the cost of lending for newly drafted financial contracts and start using alternative reference rates.

By June 2023, Libor is scheduled to be eliminated entirely.

It is imperative that the United States government implement regulatory relief, emphasize flexibility and develop concrete guidelines for financial institutions so they can easily adapt to the changing interest rate landscape. As banks and other financial institutions rewrite contracts for mortgages, credit cards, bonds, student loans and financial derivatives to adjust to fluctuating interest rates, the federal government needs to ensure that the tax burden is limited and litigation is mitigated.

According to the Congressional Research Service, as of the end of 2020 Libor was referenced in over $220 trillion financial instruments denominated in U.S. dollars, including mortgages, student loans, bonds, derivatives and more. PwC estimates that Libor is tied to as much as $350 trillion “in bonds, loans, derivatives and securitizations worldwide.” The aggregate gross domestic product for all the economies in the world pales in comparison ($84.68 trillion in 2020) to the amount of financial products connected to Libor.

The pervasive nature of Libor in financial contracts underscores its importance and how susceptible financial markets can be to distortions in the values of Libor.

Unfortunately, manipulation of Libor data forced the international financial ecosystem to move away from the reference rate. Now, financial contracts will be expected to use a new set of benchmark rates, such as the Secured Overnight Financing Rate (SOFR) and the Sterling Overnight Index Average (SONIA), which are less susceptible to collusive manipulation and based on actual trading.

However, regulators should emphasize flexibility and allow financial institutions to use benchmark rates that best suit their customers. Benchmarks such as the American interbank offered rate (Ameribor) and the Bloomberg Short Term Bank Yield Index (BSBY) are credit-sensitive and “provide a more accurate reflection of lenders’ funding costs.”

Enabling lenders to choose among a host of different rates will lead to more innovative financial products and could increase capital disbursement to borrowers.

Federal regulators also need to ensure that bonds or other contracts that extend beyond 2021 and do not include contingency plans for the Libor transition are able to avoid costly litigation, which would harm both lenders and borrowers.

Fortunately, Congress is working on a bill to provide a federal framework to allow these longer-term contracts to easily transition to new reference rates. Rep. Brad Sherman, D-Calif., introduced HR 4616, the Adjustable Interest Rate (Libor) Act of 2021, to provide a framework to ease financial institutions away from Libor for contracts that lack explicit language explaining how borrowers and lenders can transition their contract from Libor to a new reference rate. The federal framework would preempt any cumbersome patchwork of state laws that could inhibit a streamlined transition for financial contracts that cross state lines.

HR 4616 garnered strong bipartisan support and passed the House by a vote of 415-9. It is highly likely that the Senate will introduce a bipartisan bill identical or nearly identical to Rep. Sherman’s bill and pass it with little consternation.

On Dec. 14, 2021, the White House’s Office of Information and Regulatory Affairs received draft rulemaking from the IRS that would exclude loans and other financial contracts such as derivatives from facing a capital gains tax upon the alteration of the terms of the contract. This exclusion is appropriate because the amendments to the contracts do not alter the fair market value of the loan or derivative, and there is no realization of income.

The IRS concludes in the draft rule that the exemption from capital gains tax applies “to both the issuer and holder of a debt instrument and to each party to a nondebt contract.”

Accordingly, the final rulemaking would preserve the tax exemption and avoid the negative implications of imposing the burdensome capital gains tax on borrowers and lenders during the Libor transition. Application of a capital gains tax to mortgages and student loans in this scenario is unnecessary and erroneous.

As the transition from Libor continues into 2022, Congress and federal regulators need to continue to beat the drum on regulatory relief so that both lenders and borrowers can avoid costly litigation, burdensome taxation and illiquidity. This action is needed to promote continued capital allocation and ensure a steady supply of liquidity in financial markets.