Is the end of Libor a threat to financial stability?
WASHINGTON — There is little doubt in anyone's mind that by the end of 2021, the London interbank offered rate will cease to exist. But as banks prepare for the switch, a growing chorus is warning of financial-stability issues with the transition to a new interest rate benchmark.
Concerns over how seriously banks are taking the deadline have led some to worry about disruptions in the lending market. And some banks have criticized the regulator-approved successor to Libor, the secured overnight financing rate, or SOFR, saying it could cause lenders to pull back on credit.
Yet many experts say the fear is overstated. Some even compare the transition away from Libor to the Y2K warnings leading up to the year 2000, when doomsday scenarios related to the storage of calendar data never materialized.
“There will be a lot of drama” over the switch from Libor, said Dr. Richard Sandor, the chairman and CEO of the American Financial Exchange. “There will be intermittency in terms of adoption," but as the deadline comes, "the banking system will in fact embrace alternatives to Libor and it will, just like Y2K, all of a sudden happen and there won’t be any instability.”
The United Kingdom's Financial Conduct Authority has said it can only commit to publishing Libor — the rate that banks charge each other to borrow money — until the end of 2021, when banks will likely stop submitting information used to set the rate.
The Federal Reserve and the Federal Reserve Bank of New York, which convened the Alternative Reference Rates Committee that recommended SOFR as the new benchmark, have urged financial institutions they supervise to get on board as soon as possible and leave the scandal-ridden Libor in the past.
“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 Fed President John Williams said in a September speech. “Everyone in the financial services industry needs to be aware that the date when the existence of Libor can no longer be guaranteed is fast approaching.”
But with the end date for Libor approaching, and doubts persisting about the industry's preparedness, some have warned that such a massive transition could pose a systemic risk.
“I think that this poses one of the greatest potential disruptions to our financial system ever, and this is why — uncertainty,” Rep. David Scott, D-Ga., said at a House Financial Services subcommittee hearing last month. “It has a large part to play in how smoothly this transition plays out.”
And banks themselves are also nervous. In a September letter to federal banking regulators, executives from 10 regional banks said that using SOFR on a standalone basis could cause lenders to pull back, especially during economic stress, and lead to higher costs of credit.
The executives said that during "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.” The result could be a "mismatch" between bank assets and liabilities.
“The natural consequence of these forces will either be a reduction in the willingness of lenders to provide credit in a SOFR-only environment, particularly during periods of economic stress, and/or an increase in credit pricing through the cycle,” the letter said.
Instead, the banks suggested creating a SOFR-based lending framework that would include a credit risk premium, and recommended that regulators create a working group to look at the issue further.
Some of the industry's concern may stem from the fact that institutions are increasingly engaged with how the transition will affect them.
“Every type of institution is still in the process of figuring out, what would the economics of SOFR mean to my bank, my institution, if I use that instead of Libor or instead of Libor in some situations?” said Hu Benton, vice president of banking policy at the American Bankers Association. “And it’s just because that understanding is still being worked out that I think people are really focused on this."
Sandor said the ubiquity of Libor, which is the standard for an array of financial instruments, partly explains the unease about the transition. He has created an alternative interest rate benchmark, Ameribor, which is based on unsecured transactions on the American Financial Exchange and reflects the borrowing costs of a wide range of U.S. banks.
"Libor is unique in that there’s one benchmark,” he said.
Meredith Coffey, co-chair of the ARRC’s business loans working group, said the transition to a new benchmark is no easy task but is one that the committee has been working diligently behind the scenes to address.
“I wouldn't say there's no risk, but people recognize that there are substantial challenges and they are mobilizing,” said Coffey, the executive vice president of research and public policy at the Loan Syndications & Trading Association.
For example, in dealing with preexisting loans that were made using Libor but that will be affected by the switch to SOFR, the ARRC has developed fallback language for loan documents.
It is “language you can include in documents people are entering into now since there’s no real agreement on how exactly the replacement rates will work,” said Ramya Tiller, a partner at Debevoise & Plimpton.
That was a crucial step, said Coffey, who estimated that about 97% of loans completed between 2018 and 2019 included this fallback language. "We basically have a process by which to go from Libor to SOFR,” she said.
It still remains to be seen whether or not the federal banking regulators will take up the suggestion from regional bank executives to form a working group or to consider incorporating a credit risk premium into a SOFR-based framework. Experts say market participants may have to get used to the fact that SOFR might not include a credit-sensitive element.
Credit risk premiums may have become outdated for multiple products, Coffey said.
“I'm sympathetic to regional banks' concerns. They're used to having that in Libor,” she said. “But I'm not really sure at the end of the day how it would be executed robustly for SOFR.”
The ARRC has examined various methods of calculating a risk adjustment over various periods, and now market participants need to coalesce around one method to ease the transition, said Tiller.
“What would not be ideal from anyone’s perspective is to have one way of calculating the risk adjustment in the derivative product, but a different way for the cash product,” she said.
Still, with more than two years left before the likely demise of Libor, it’s difficult to say what risk the transition poses to financial stability, Tiller said.
“Obviously part of the challenge here is that the regulators want people preparing for transition and they want a product to develop around these new replacement rates so that there is liquidity in the market when you finally have to transition,” she said.
Sandor said the idea that a single new interest rate benchmark would seamlessly and ubiquitously replace another is “fallacious.”
"These things take years and it's not going to be a magical pill and all of a sudden one [benchmark] is going to emerge,” he said. “If it does, it's going to be the first time in 500 years of western economic thinking."