The transition from U.S. dollar (USD) London Interbank Offered Rate (Libor) to its likely replacement, the Secured Overnight Funding Rate (SOFR), presents heightened risks for U.S. financial institutions (FIs), Fitch Ratings says. Banks may face greater legal, operational and reputational challenges from cash products, which have lagged derivatives in moving away from Libor. Rating changes are not anticipated over the near term. However, failure to plan accordingly and manage the inherent risk related to this event could negatively affect ratings.

Derivatives notionally make up an overwhelming majority of the instruments referencing USD Libor, with gross notional exposures as of YE16 of $199 trillion. The expected protocol from the International Swaps and Derivatives Association should lessen transition risks compared to cash instruments.

While cash products represent a significantly smaller portion of affected USD Libor instruments than derivatives, the absolute number of underlying contracts poses a considerable level of risk given the wide range of document standards and variations in the types of fallback language used at FIs. Repapering and renegotiating existing Libor contracts will depend on the level of consent required, which varies by the type of instrument. A legislative solution may need to be pursued given the breadth of issues related to amending legacy cash products and obtaining contractual consent.

Litigation from counterparties (both institutional and retail) is a primary risk to U.S. FIs if existing contracts have inadequate fallback provisions or language. This risk could lead to increased reputational risk if counterparties perceive changes to the terms of contracts disadvantage them relative to the financial institution.

Fitch expects that some FIs will feel compelled to absorb a certain level of losses to minimize any reputational risk from change in the terms that may perceive to benefit the lender at the expense of the customer, particularly retail debt products. In situations not affecting retail customers, banks and other FIs may still feel compelled to proactively address or to remedy situations that would otherwise lead to outsized value transfer in an effort to minimize reputational risk.

Consumer protection laws in the U.S. may also be hindering the issuance of SOFR-based consumer loans, exacerbating the market's slow acceptance of SOFR for lending products. To date, only three SOFR-based loans have been originated. Fitch expects increasing regulatory scrutiny directed at this issue in 2020.

Operational risks may prove most challenging for banks or FIs with smaller scale and fewer resources. Smaller firms rely more on outsourcing loan processing and management to third-party vendors, which increase risk if these vendors have not properly tested their systems or fail to calculate the replacement rate correctly. Fitch has little visibility into smaller FIs' exposure to USD Libor; however, small banks with less than $1 bil. in total assets (85% of the banks in the U.S. by count) usually have more exposure to commercial real estate and residential mortgage loans, which tend to be less tied to USD Libor than commercial and industrial (C&I) loans.

The largest U.S. banks are expected to address and mitigate operational risk of Libor cessation effectively given the large dedicated transition work-streams in place. Larger banks tend to have a greater focus on C&I loans, the loan category that most often references Libor; however, variable-rate mortgages also typically reference Libor. Clearinghouses have also begun rolling out SOFR-based derivatives while seeking to address the operational risks accompanying new product introductions.