The benchmark rate used for trillions of dollars' worth of loans has an expiration date, and regulators are saying some banks have not done enough to prepare for the potentially disruptive transition.
U.K. regulators have said they will force the retirement of the London interbank offered rate by year-end 2021. The benchmark interest rate is tied to approximately $400 trillion worth of financial contracts across the world. Regulators are moving to phase out the rate after finding widespread manipulation. To prevent a repeat of the scandal, regulators are pushing for replacement rates to ditch Libor's survey-based methodology in favor of actual transactions. There are several potential replacements, muddying the post-Libor outlook. But regulators and consultants say there is plenty banks can be doing today, such as inventorying current exposure, adopting "fallback" language and creating special committees to prep for the change.
Some of the world's top banking regulators are urging the industry to take action. On June 5, Bank of England's deputy governor said he was "very surprised" at the lack of preparedness across the industry. On June 3, Federal Reserve Vice Chair Randal Quarles pressed banks to "take the warnings seriously" about the expiration of Libor and its potential ramifications.
"There are a good number of institutions that are taking a head-in-the-sand approach with respect to the transition and are probably not preparing as adequately as they could," said Todd Cuppia, managing director for Chatham Financial, a financial advisory firm specializing in debt and derivatives markets.
At the other end of the spectrum, some banks have already jumped to alternative options. Boston-based community bank Brookline Bancorp Inc. announced that it would pilot a program for about $40 million of loans indexed to a fledgling replacement rate, the American Interbank Offered Rate, or Ameribor. Richard Sandor, a pioneer of interest rate future products, founded Ameribor in an effort to cater to regional and community banks in the U.S. The rate is based on borrowing and lending transactions executed on the American Financial Exchange, which has 144 members and an average daily volume of nearly $2 billion. So far, the index has hovered at approximately 10 basis points to 15 basis points higher than Libor, reflective of the modestly higher borrowing costs for community banks compared to their multinational peers.
"America's 5,000 regional, midsized and community banks don't own government securities. They own mortgages. Therefore, there is a different need for those 5,000 banks," Sandor said in an interview. He said he foresees the market replacing Libor with several benchmarks from which banks can pick and choose.
U.S. regulators have so far recommended a single replacement rate: the Secured Overnight Financing Rate, or SOFR. The Federal Reserve Bank of New York publishes the rate based on overnight transactions collateralized by U.S. Treasury securities. In 2014, the New York Fed and the Federal Reserve founded a group called the Alternative Reference Rates Committee to smooth the transition from Libor. On May 31, the committee issued recommended "fallback" language — clauses to be included in instruments that dictate what happens after Libor expires.
However, bouts of volatility in SOFR have raised concerns about the index's stability. On Dec. 31, 2018, the rate spiked more than 50 basis points from the previous day of trading. Regulators have responded that the volatility is misleading since most lenders are using moving averages that have proven less volatile than Libor.
"The volatility topic makes for good headlines, but I don't think it's factually accurate because in many cases, firms are using the monthly average or quarterly average," said Nitish Idnani, a principal with Deloitte Risk & Financial Advisory.
Idnani said he expects the market to determine whether U.S. banks can switch to SOFR or use multiple benchmarks. Intercontinental Exchange Inc. also has a potential replacement: the ICE Bank Yield Index, which is based on wholesale funding transactions for large, internationally active banks. And some market participants believe Libor will not be phased out by year-end 2021 since banks could potentially volunteer to keep publishing the index despite the exit of U.K. regulators, which have historically maintained it.
But even if banks cannot divine which index will replace Libor, consultants said there is plenty that can be done now. Idnani said banks need to think critically about any and all instruments that could be tied to Libor, ranging from loans to derivatives contracts to their own debt issuances. He said forward-thinking banks have started to identify the extent of exposure and are working to digitize all the relevant contracts so they can be updated when a replacement benchmark is selected.
In addition to producing such an inventory of Libor exposure, banks should establish committees that include executives across all verticals of the organization — such as compliance, legal and treasury — to ensure appropriate coordination, said Adam Gilbert, a partner for PwC's financial services advisory business.
"This is a hydra-headed challenge," Gilbert said. "As a first step, you've got to find out what's there. And then you have to go beyond that. ... There's a ton of work to do here. It's very real and people have to get on it."