Letter to Credit Unions 21-CU-03 LIBOR Transition
NCUA issued LTCU 21-CU-03 to discuss issues related to the end of the publication of the London Inter-bank Offered Rate (LIBOR) and provide credit unions with the related Supervisory Letter 21-01 “Evaluating LIBOR Transition Plans” that NCUA issued to its examiners.
NCUA’s guidance follows guidance issued in November 2020 by the federal bank agencies, the FFIEC’s July 1, 2020, Joint Statement on Managing the LIBOR Transition, and the March 5, 2021, announcement by the LIBOR administrator that it will cease publication of the one-week and two-month LIBOR settings immediately following publication of the December 31, 2021, LIBOR. The remaining LIBOR benchmarks will cease publication after the LIBOR publication on June 30, 2023.
The NCUA encourages all federally insured credit unions to transition away from using the U.S. dollar LIBOR settings as soon as possible, but no later than December 31, 2021.
Summary of NCUA’s Supervisory Letter 21-01 “Evaluating LIBOR Transition Plans”
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). Current USD LIBOR settings include overnight, 1 week, & 1, 2, 3, 6, & 12-month rates. A partial timeline of events leading to the current need to transition away from LIBOR includes the following key dates:
- July 2017 – actions by European regulators (for deep background click here) set in motion developments leading to the announced end of LIBOR publication.
- July 2020 – FFIEC Joint Statement on Managing the LIBOR Transition highlighted the risks resulting from transition away from LIBOR. NCUA & other bank regulators advise institutions to avoid using LIBOR no later than 12/31/ 2021.
- November 2020 – A clearer transition path away from LIBOR develops when it is announced some LIBOR rates might be published beyond 12/31/2021.
- March 5, 2021 – Announcement that 1-week and 2-month USD LIBOR will cease publication after 12/31/2021. Remaining USD LIBOR settings will cease after June 30, 2023 allowing existing transactions indexed to the more widely-used LIBOR settings to mature naturally.
NCUA believes that given consumer protection, litigation, and reputation risks, entering new contracts using LIBOR as a reference rate after December 31, 2021, would create safety and soundness, and compliance risks. FICUs should not be entering new contracts that use LIBOR as a reference rate unless they have robust fallback language that includes a clearly defined alternative reference rate, specific triggers, a spread adjustment, and some description of the conforming changes that are necessary.
II. Potential LIBOR Exposure
Credit unions may have LIBOR exposure in a variety of products & transactions, including derivatives, business loans, consumer loans, variable rate notes, securitizations (such as mortgage-backed securities), FHLB borrowings, and other products that have variable interest rates.
NCUA notes examiners should consider potential LIBOR exposure in the following products/portfolios and review for material LIBOR related risk:
- Real Estate Loans
The adjustable-rate mortgage (ARM) is traditionally the most common product incorporating LIBOR as a benchmark. Credit unions could originate an ARM using loan underwriting standards established by a GSE such as Fannie or Freddie which also provide fallback language if LIBOR is no longer available. ARM mortgages that conform to GSE underwriting standards that credit unions originate represent low LIBOR risk.
For non-conforming or customized ARMs that a credit union has originated and held in its portfolio, NCUA instructs its examiners to determine if an ARM has robust fallback language in the event the variable rate index is no longer available.
- Other Loans
Credit unions also hold a significant amount of LIBOR-indexed student loans. NCUA notes that the potential for a high number of individual student loan accounts, combined with the likelihood of frequent borrower address/employment changes, may complicate credit union efforts to communicate rate changes to borrowers. For credit unions holding significant numbers of LIBOR-indexed student loan accounts, NCUA examiners will consider:
- Reviewing the credit union’s transition plan
- Checking for fallback language
- Determining if the credit union has dedicated sufficient resources to make any needed modifications to 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.
Legacy LIBOR-indexed securities remain a significant percentage of variable rate assets held by credit unions. However, LIBOR-indexed investments typically have bond trustees that represent investors and who are responsible for implementing robust fallback language to a new reference rate or rates in the transition away from LIBOR. Therefore, examiners may review such holdings with a low level of concern.
As of September 27, 2019, the FHFA directed the FHL Bank System to stop entering into LIBOR-based transactions involving advances with terms that mature after 12/31/2021. In July 2020, FHLB member banks were asked to identify LIBOR-indexed loans that are listed as collateral. NCUA examiners may evaluate 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.
NCUA expects examiners to understand the credit union’s rate-setting methodology and to determine whether any repricing indexes are LIBOR-based. NCUA notes that most dividend rates paid on share accounts (e.g., money market, regular shares, & share drafts) are set by the credit union’s board rather than contractually tied to LIBOR.
Interest rate derivatives are generally the largest transaction exposure to LIBOR risk for financial institutions; however, this exposure is significantly smaller in credit unions. Derivative transactions are governed under an International Swaps and Derivatives Association (ISDA) agreement. In 2020, ISDA launched its Fallbacks Supplement and Fallbacks Protocol which amend ISDA’s standard definition for interest rate derivatives to incorporate robust fallbacks for derivatives linked to a key interbank offered rate. These changes became effective January 25, 2021. Centrally cleared swaps can be considered low risk, as can bi-lateral swaps for which counterparties have signed the ISDA protocol.
III. LIBOR Replacement Alternatives
NCUA does not endorse a specific replacement rate for USD LIBOR and the choice of reference rate is a business decision left to the credit union to determine what is appropriate (other than continuing to use LIBOR).
NCUA reiterates: 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.
NCUA notes that there may be some contracts for which amending to address the discontinuance of LIBOR would be difficult or impossible. For contracts governed by NY law (as many financial contracts are) new legislation enacted in April addresses legacy contracts that mature after June 2023 and do not have effective fallbacks by:
- 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.
Secured Overnight Financing Rate
While NCUA does not endorse a specific replacement index, NCUA’s guidance provides credit unions information on the alternative rate recommended by the Alternative Reference Rates Committee (ARRC). The ARRC was a joint FRB, CFTC, Treasury and Office of Financial Research initiative to identify an alternative to LIBOR. In June 2017, the ARRC selected the Secured Overnight Financing Rate (SOFR) as its recommended alternative to the USD LIBOR. 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.
IV. Examination Considerations
NCUA is instructing its examiners to review credit union planning for the transition away from LIBOR through narrowly focused reviews tailored to the size and complexity of a credit union’s LIBOR exposures. The following criteria will be used to determine if a credit union’s LIBOR risk is minimal:
- 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 1, 3, 6, & 12 – 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.
The following are 6 risk areas examiners will use as a guide:
1) Transition Planning – Credit unions should be transitioning away from LIBOR by end of 2021 and that transition plans should be commensurate with the LIBOR exposure. 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.
2) 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 including details on products, contracts, balances and transition costs.
3) Operational Preparedness and Risk Control – Credit unions need to identify any internal or vendor provided systems and models that use or require LIBOR and establish contingency plans if a TSP cannot transition away from LIBOR.
4) Contract Preparedness – Credit unions should identify any contracts that reference LIBOR and not enter into new contracts that do not contain fallback language. Transition plans should address how management will determine the impact of the end of LIBOR on existing contracts and any needed mitigation.
5) Communication – FICUs should communicate the implications of the LIBOR transition on impacted financial products to their counterparties and members and mind compliance with applicable laws and regulations such as Truth in Lending Act. For more information, see NCUA’s Federal Consumer Financial Protection Guide.
6) Oversight – 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 have been instructed to document their LIBOR exposure findings in the revised LIBOR Alternative Readiness Workbook and to communicate any findings and recommendations to the credit union’s board and management through the ROE.