Banks fret over life after Libor

As the global financial system braces for the death of Libor — the benchmark for interest rates on trillions of dollars in loans and other contracts — some banks are getting increasingly jittery about its replacement.

The banks warn that tying their loans to the Secured Overnight Financing Rate, the official alternative to dollar-based Libor, could squeeze their bottom line when the U.S. economy inevitably enters a downturn.

The reason: The London InterBank Offered Rate, as its name suggests, is based on the rate that top banks would charge each other for unsecured loans, while SOFR is based on rates for overnight loans secured by Treasuries. And the two rates behave quite differently.

“We believe that SOFR, on a stand-alone basis, is not well-suited to be a benchmark for lending products and have concerns that this transition will adversely affect credit availability,” 10 regional banks wrote to their regulators last month in a letter, obtained by POLITICO.

“During times of economic stress, SOFR (unlike Libor) will likely decrease disproportionately relative to other market rates as investors seek the safe haven of U.S. Treasury securities,” they added. “In that event, the return on banks’ SOFR-linked loans would decline, while banks’ unhedged cost of funds would increase, thus creating a significant mismatch.”

It’s one of a whole range of issues that market participants are working through as they move away from Libor and toward a fundamentally different reference rate. But the clock will be running out in two years, and financial experts leading the transition warn against focusing too much attention on recreating something like Libor, which has proven elusive.

“Our response really has been, look, the ARRC was really not formed to replicate Libor,” said Morgan Stanley’s Tom Wipf, who chairs the private-sector Alternative Reference Rates Committee that selected SOFR as the official alternative for dollar Libor and continues to work through the questions raised by the transition.

“We were tasked with identifying a suitable replacement that didn’t have the structural flaws inherent in Libor,” he said. “Work around trying to replicate [a rate that behaves like Libor] — many have tried, but no one has really gotten to it. We hit a dead end in every case.”

That’s because the actual volume of transactions used to determine Libor has dwindled, making its value much more of an art than a science. The rate also became infamous in 2012 after it was revealed that some banks had been colluding to manipulate it. SOFR, meanwhile, has been in the spotlight in recent weeks as a result of volatility in the overnight funding markets that determine its value.

So, while banks are worried about how real market behavior might affect SOFR, the problem with Libor is that it’s largely guesswork.

The Financial Conduct Authority, the independent U.K. body that regulates financial firms, has not committed to mandating publication of Libor past the end of 2021. No one is completely sure when Libor will go away, although regulators are cautioning banks not to wait and find out.

“Some say only two things in life are guaranteed: death and taxes. But I say there are actually three: death, taxes and the end of Libor,” New York Federal Reserve President John Williams said in a speech last month.

But while banks don’t take issue with tying derivatives to SOFR, a number of larger lenders have underscored the need for an option for products like business loans, commercial real estate loans and adjustable-rate mortgages that is more closely tied to their funding costs.

Banks now do less short-term unsecured borrowing than they did before the 2008 financial crisis and receive much of their funding through deposits and longer-term debt issuances. Although many long-term bonds are issued at a fixed rate, for hedging purposes banks often link them to derivative contracts that tie their interest payments to Libor.

In the absence of Libor, the regional banks in their letter suggested a “dynamic spread” could be added on top of SOFR to make it behave more like Libor.

“Including credit sensitivity as part of the framework is the most straightforward approach to achieve this alignment, as it enjoys the benefits of using SOFR as a robust underlying rate and does not require complex hedging strategies which are ill-suited for smaller Main Street lenders and community banks with less complex balance sheets,” wrote the banks, which include Capital One, Fifth Third, PNC and Regions.

But SOFR proponents, as well as FCA Chief Executive Andrew Bailey, have downplayed the workability of that idea. “If this could be accomplished, it would probably already have been done,” Bailey said in a speech this summer. “For this reason, we do not see synthetic solutions as a part of a long-term solution to evolving Libor.”

Brian Grabenstein, head of Wells Fargo’s Libor Transition Office, noted that any data set reflecting banks’ unsecured funding costs wouldn’t contain enough transactions for a robust rate with the same scope as Libor.

“Potentially you could get comfortable with a smaller data set backing an index that’s only going to be used for a subset of what Libor’s used for today, but even then you have some pretty fundamental questions,” like whether transactions in that index might dry up at exactly the wrong time, he added.

The Fed, which is facilitating the transition discussions, has expressed some sympathy for the SOFR complaint but hasn’t made it a front burner topic of discussion while other issues remain unresolved.

“[New Libor alternatives] may be less fit for new lending products because they don’t contain a credit-sensitive element,” Fed regulatory chief Randal Quarles said earlier this month in Brussels. “We will have to work on figuring out what that credit-sensitive element is.”

The banks who sent the letter asked Quarles, along with FDIC Chairman Jelena McWilliams and Comptroller of the Currency Joseph Otting, to support the creation of a private market participant industry working group on this topic. A Fed spokesperson said the central bank has received the letter and is considering the issues it raises.

In the meantime, ARRC leaders and regulators continue to try to convey urgency for institutions to make the transition.

“There’s simply nothing comparable to SOFR,” said Meredith Coffey, executive vice president of research and policy at the Loan Syndications and Trading Association. “In addition to being underpinned by $1 trillion of daily trading, SOFR is easily hedged through derivatives, aligned with floating rate notes and similar to rates that will be used in the U.K. and Europe. Since SOFR is likely where we end up, the quicker we get there, the better.”