A significant portion of our transactions involve variable or adjustable interest rates that are calculated by adding a contractually defined credit spread to a base or reference rate. Until recently, LIBOR was the reference rate used for a substantial majority of our transactions involving variable or adjustable interest rates, including those in which we lend money, issue securities, or purchase and sell securities issued by others, as well as many derivative transactions that we enter into to manage our or our customers’ risk. We also service variable or adjustable-rate financial instruments entered into by others that have historically commonly used LIBOR as the reference rate. Based upon guidance communicated by the Federal Reserve and other official sector representatives, PNC stopped entering into new USD LIBOR contracts as of December 31, 2021, subject to certain limited exceptions. However, we maintain a sizable book of owned and serviced LIBOR reference rate assets. For more information on our LIBOR reference rate assets, see the Market Risk Management portion of the Risk Management section of this Report.
As announced by ICE Benchmark Administration Limited and the U.K. Financial Conduct Authority, as of June 30, 2023, the current form of USD LIBOR will no longer be available, and any alternative form of USD LIBOR published using a new methodology for rate calculation (i.e., “synthetic LIBOR”) would not be a “representative” rate. As a result, most USD LIBOR reference rate assets will require a replacement reference rate on or about that time. That replacement reference rate will either be implemented consistent with contractual terms or by operation of law.
Currently, SOFR is the alternative reference rate replacing USD LIBOR for most types of transactions and, under recently enacted federal legislation addressing LIBOR cessation, is the replacement reference rate to be used for certain LIBOR contracts when LIBOR cessation occurs, including those that do not include terms for determining a replacement reference rate. LIBOR and SOFR are based on different inputs. LIBOR is intended to reflect the borrowing cost of certain global banks, while SOFR is derived from rates on overnight U.S. Treasury repurchase transactions, which are essentially overnight loans secured by U.S. Treasury securities. To address differences between LIBOR and SOFR, certain industry-recommended LIBOR contract provisions that provide a mechanism to transition to a SOFR reference rate include the concept of an adjustment spread. The adjustment spread is applied when a LIBOR-based contract moves to the SOFR replacement reference rate. These recommended adjustment spreads are based on a five-year median look-back of the historical spot difference between the applicable LIBOR tenor and the applicable SOFR tenor and were fixed on March 5, 2021 as a result of announcements by ICE Benchmark Administration (the administrator of LIBOR) and the UK Financial Conduct Authority (the regulatory supervisor of the IBA) of the dates after which all LIBOR settings will either cease to be provided or will no longer be representative. The same adjustment spreads will also be operational under current federal law.
Changing the reference rate to SOFR is highly likely to result in some value transfer between parties to instruments originally based on LIBOR, and we have experienced some value transfer in connection with instruments that have been amended away from LIBOR in anticipation of its cessation. That value transfer arises because no reference rate will replicate LIBOR exactly, and, accordingly, any replacement reference rate will not behave identically to LIBOR over time.
Any value transfer could be financially adverse or beneficial to us or to the other contracting parties (such as a borrower, derivative counterparty or bond holder). Impacts from a change in reference rate would likely include changes to the yield on, and value of, loans or securities held by us, amounts paid on securities we have issued, amounts received and paid on derivative instruments we have entered into and the trading market for LIBOR-based securities. Any theoretical benefit to us could result in counterparty dissatisfaction, which could impair relationships that result in loss of business or could lead to litigation (potentially as class actions). As a result, over the life of a transaction that transitions from LIBOR to a replacement reference rate, our monetary obligations to a counterparty (or its obligations to us) and the yield we receive (or pay) from the transaction with that counterparty may change from that which would have resulted from a continuation of LIBOR.
Another set of risks associated with LIBOR cessation relates to how the transition from LIBOR to another rate will be implemented. For some instruments, the method of transitioning to a replacement reference rate may be challenging, especially where the contract does not provide for a transition upon LIBOR ceasing or becoming a nonrepresentative rate, or where the relevant contractual language relating to a potential transition is ambiguous or inadequate under the circumstances.
For example, most bilateral, uncleared LIBOR-based interest rate derivative contracts executed prior to January 25, 2021, did not include adequate contractual provisions to address LIBOR cessation. In response, ISDA published a protocol pursuant to which industry participants can agree with any other industry participant that adheres to the protocol to include ISDA’s new LIBOR replacement provisions into legacy derivative contracts. However, the new ISDA replacement provisions and the replacement provisions that have been adopted for loans would result in a mismatch between the replacement reference rate included in our borrowers’ legacy derivative contracts and their loans for which such derivative contracts are intended as a hedge. Further, although we have adhered to the ISDA protocol, many “end users” of swaps (i.e., our borrowers who have hedged their interest rate payment obligations) have not adhered, and we do not expect them to adhere. For these end-user counterparties, one-on-one negotiation with each counterparty is necessary to amend legacy derivative contracts to adequately address LIBOR ceasing or becoming a non-representative rate. If we are unable to agree to appropriate LIBOR cessation provisions with these counterparties, the federal law addressing LIBOR cessation will incorporate replacement provisions into these derivative contracts. However, the statutory replacement provisions may not align with replacement provisions in a loan for which the derivative contracts are intended as a hedge. As a result, addressing transition under these circumstances may be challenging, increases the risk of counterparty dissatisfaction, and, in some cases, may involve concessions on our part that have the effect of reducing the value of those instruments to us.
The PNC Financial Services Group, Inc. – 2022 Form 10-K 19
The PNC Financial Services Group, Inc. – 2022 Form 10-K 19
The PNC Financial Services Group, Inc. – 2022 Form 10-K 19
We have other contracts that do contemplate the cessation or nonrepresentative status of LIBOR, but they do so in manners that may create other risks. For example, some contracts provide for selecting replacement rates in a manner that presents significant challenges (such as by assuming that there would be a rate calculated substantially in the same manner as LIBOR is calculated) or that gives us or another party absolute discretion to select a replacement reference rate. Some provide for determination of a replacement reference rate without providing for use of an adjustment spread to account for the difference in the reference rates. In these types of cases, there will likely be uncertainty surrounding transition, in addition to all of the risks described in this Risk Factor.
Transitioning from LIBOR to alternative reference rates also may result in operational errors during the transition such that the replacement rate is not applied in a timely manner or is incorrectly applied. This is particularly true given the volume of contracts that will require transition, the diversity of potential approaches to transition and the possibility that the period during which the transition will need to take place may have a short duration. Our failure to successfully implement the transition from LIBOR to alternative reference rates increases the risk of regulatory scrutiny and actions by our regulators, including fines and other supervisory sanctions. It is also possible that LIBOR quotes will become unavailable prior to the currently anticipated cessation dates. In that case, the risks associated with the transition to an alternative reference rate will be accelerated and magnified. These risks may also be increased due to the shorter time for preparing for the transition.
Transitioning from LIBOR to alternative reference rates also impacts certain of our hedge accounting strategies. Uncertainty about the application of ASC 848 Reference Rate Reform to pooled cash flow hedge strategies introduces accounting risk that could affect our ability to apply this accounting in the future. See Note 1 Accounting Policies for more information about reference rate reform accounting standards impacts.
To address LIBOR cessation and the associated risks, we have established an enterprise LIBOR transition program. Any failure of this program to appropriately assess and mitigate risk and deliver in a timely manner on operationalizing our ability to transition from LIBOR to alternative reference rates could magnify the risks previously outlined.