After being tied to bank scandals and a decrease in participation of reporting banks, the London Interbank Offered Rate (LIBOR), which is a standard financial index used in U.S. capital markets, is set to be phased out after 2021. Many dealerships are dependent on LIBOR for financing instruments such as vehicle floor plans, mortgages and interest rate swaps. What should you be aware of that could affect how you finance in the future?
What is the LIBOR rate?
LIBOR is a benchmark rate for what a select group of banks charge each other for short-term loans. It serves as the first step to calculate interest rates on various loans throughout the world. Since LIBOR is so prominent, it is also used in other transactions such as the floating rate on interest rate swaps.
Why is a change needed?
After the financial crisis of 2008, there was a decrease in the activity of banks borrowing from one another. As a result, many of the banks that were reporting interest rates to calculate the LIBOR rate were unrepresentative of the underlying market because they did not participate in those transactions. This forced those banks to submit a rate based on their expert judgment with little to no supported data from actual activity.
In the spring of 2013, the Financial Conduct Authority (FCA) took over regulating the LIBOR rate and improvements were made to controls for the 20 banks that agreed to continue reporting rates. On July 27, 2017, Andrew Bailey, Chief Executive Officer of the FCA, stated they have begun work on replacing the LIBOR rate with an alternative rate that is based firmly on actual transactions instead of management’s expert judgment.
What does this mean for your dealership?
This change in the LIBOR rate means that within the next four years, your dealership could be impacted with a new method of charging interest on your outstanding debt. If you have your floor plan or any loans with an effective rate based on the LIBOR rate, there are a few questions you should be discussing with your financial provider to determine how to prepare for this change:
- How will my effective rate be determined in the future?
- How will this impact my debt that extends beyond 2021?
- What impact will this have on my debt covenants?
- Will all of my loan documents need to be revised?
What will change and when?
The FCA has stated it will take at least four to five years to plan and execute a smooth transition that will not cause extreme unnecessary costs. The current timeline is for the LIBOR rate to be phased-out by the end of 2021.
There have been various steps taken to find an alternative replacement. As of today, the Risk Free Rate Working Group in U.K. has proposed the Sterling Overnight Interbank Average rate (SONIA), which is an index that tracks the Sterling overnight funding rates. Additionally, the Alternative Reference Rates Committee in the U.S. has proposed a broad Treasuries repo rate. Both rates are anchored in more active markets than the LIBOR rate and don’t take into consideration expert judgment. This will avoid favoritism to those entities who chose to be in the reporting panel because the rates will be pulled from actual transactions.
While getting all financial firms to agree and convert to a new rate is not going to be easy or quick, the change is an important effort to strengthen the international financial system.
For more information on this topic, or to learn how Baker Tilly dealership specialists can help, contact our team.