interest rate by Mike Cohen is licensed under CC BY 2.0

In an op-ed published in American Banker today, ATR Federal Affairs Manager Bryan Bashur highlights the importance of providing regulatory relief and flexibility for financial institutions as they transition away from using the London Interbank Offered Rate (LIBOR) as a gauge for how much interest to charge on certain financial products. Trillions of dollars in contracts for mortgages, credit cards, bonds, student loans, futures, swaps, and options, will all feel the effects of this transition. As Bashur explains:

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.

As LIBOR is phased out and new benchmark interest rates will be widely adopted, it is imperative that banks and other financial institutions are able to use reference rates that best suit their products and the customers they serve. As Bashur points out:

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.

Some long-term financial contracts that use LIBOR do not include plans for how to adjust the terms when LIBOR is fully discontinued. However, Congress is working on legislation to provide a more concrete framework to ease the transition. Bashur states that:

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.

One example of regulatory relief during the LIBOR transition is a rulemaking the IRS published that exempts financial contracts from capital gains tax if the terms of the contract are amended to reflect the change in benchmark interest rates. Bashur elaborates that:

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.

Bashur urges Congress and federal regulators to continue the stream of regulatory relief “so that both lenders and borrowers can avoid costly litigation, burdensome taxation and illiquidity.”

Click here to read the full op-ed.