Libor is going dark in 2021, and some banks aren’t ready
WASHINGTON — Industry insiders are worried some banks are not paying enough attention to the likely switch to a new interest rate benchmark.
Regulators appear ready to replace the London interbank offered rate — marred by scandal in recent years — with a new benchmark known as the secured overnight financing rate as early as 2021.
But concern is growing that not all financial institutions are focused on adopting the new rate.
“As we look at this transition from Libor to a new index at the end of 2021, we see 2019 as a year to increase awareness and to encourage banks to begin preparing,” said Mike Wilson, president of the Federal Home Loan Bank of Des Moines. “It’s not a doomsday situation, but it’s really time to start thinking through how the transition is going to work and how it affects their balance sheet.”
Hu Benton, vice president of banking policy at the American Bankers Association, said the challenge for the industry right now is that, while many banks know their exposures or are working to quantify their exposures, some banks just aren’t thinking about reference rates at all right now.
“Anybody you ask who cares … all believe there is work to do to get it on the radar screen of everybody whose screen it should be on,” Benton said. “That’s a big deal.”
The United Kingdom's Financial Conduct Authority — which sanctions the panel of large banks that help set Libor — has said that it can only commit to publishing rate until the end of 2021. After that time, banks can drop out of the panel, and if too many choose that path, Libor could simply cease to exist or carry on in a diminished fashion.
In 2014, the Federal Reserve Board and the Federal Reserve Bank of New York convened an Alternative Reference Rate to identify a successor to Libor, with SOFR emerging as the strongest contender. Whereas the past scandal involving major banks' manipulation of Libor laid bare a central problem with the rate — that it is based on only a small number of actual transactions — SOFR is based on overnight reverse repurchase agreements that offer a deep and liquid market with far more transactions to use as a base.
In April, the New York Fed began publishing the daily the SOFR along with two other reference rates based on overnight repos.
Libor dates back to the 1980s, when it was developed by the British Bankers' Association as part of an effort to create some uniformity in the burgeoning market for interest rate swaps.
The rate is based on quoted interest rates at which banks provide unsecured loans to each other, and over the last several decades has found its way into almost all financial contracts that have a variable interest rate component.
But in 2012, bank and market regulators in the U.S. and elsewhere brought enforcement actions against several of the world’s largest banks for manipulating and colluding to manipulate the Libor rate to their advantage, resulting in billions of dollars in court settlements.
The transition to SOFR has not been seamless. For starters, new futures, swaps and loans have to be floated referencing SOFR to gradually displace the Libor-referencing contracts. CME Group, one of the world’s biggest futures and swaps exchanges, launched a SOFR-referencing futures contract in May. More recently, the Federal Home Loan Banks launched a $4 billion, six-month SOFR-linked bond to try to boost adoption of the new rate.
David Bowman, a senior adviser at the Fed, said the adoption process is proceeding reasonably well, and he expects that it will continue to be adopted more as the markets for the SOFR-linked products deepen.
“SOFR futures have gotten off to a very strong start, and the debt issuance that people have done based on SOFR has been really key in showing people that they can use SOFR in cash products,” Bowman said. “Overall we are where I think we need to be and where we hoped we would be at this stage. But it is key that we build up liquidity.”
But not everyone is getting the memo, and Benton said that is causing some concern that banks weighing whether SOFR works for them might wait too long. Libor’s strength is in its predictability, he said, and that can be a hard thing to replace.
“It’s what everybody kinds of wishes they could cling to, but there’s a growing realization that there’s some serious operational risk in doing that,” Benton said.
John Fisk, chief executive of the Office of Finance for the Federal Home Loan Banks, said that it is imperative that banks begin to assess their vulnerabilities and figure out how they intend to navigate the changes — and the sooner the better.
“You’ve got three years from January 2019, and you’ve got to make this among your priorities for the next year,” Fisk said. “I think it all comes down to preparing now and not waiting until 2021 to start.”
Bowman said the smaller banks with less derivative exposure are rightly waiting for the markets to deepen before they make the transition. But putting off the transition can also mean that banks might not be getting their arms around the scope of their exposure, and the more time they have to make the transition, the better off they will be, he said.
“If you’re a middle or smaller-sized bank, I don’t think you have to be the first mover here,” Bowman said. “But you can and should be getting a firm grasp on all your exposures to Libor, talking to customers about the potential risks, and consulting vendors to make sure they can offer you the appropriate help with the transition. The sooner those conversations happen, the sooner you can begin to formulate a plan to transition to SOFR as the market develops.”
And it isn’t just smaller banks, either. Benton said banks of all sizes are focused on the transition, but banks of all sizes are putting it off.
“A range of different banks are already involved, and a similar range of banks are still trying to get the right focus on it — or we’re not sure they have the right focus on it,” Benton said.
Wilson said he thought that banks with the largest exposures — those with swaps trading desks, for example — tend to be the ones that are working the most diligently on the issue because they know they have a lot of work to do.
In all cases, banks will have to engage with their customers and explain to them the change in their contract terms, but with larger banks, their customers are more likely to be other financial institutions that understand the issue more easily. Smaller banks may have to explain the changes to non-experts, which can take time. And SOFR is not the only reference rate out there, and they may need to decide whether it works for them.
“I’ve talked to some banks that are aware of the transition away from Libor, [but] they’re not convinced that SOFR is the best index,” Wilson said. “They may say, ‘On my liability side, I’ll have some debt tied to SOFR, but I’m going to index my loans … to prime.' Or, 'I’m going to tie it to the Federal Home Loan Advance Rate.' Or they’ll tie it to some other index. I think once you go to the larger institutions, they’ll have more SOFR-based assets and liabilities. That’s where there will have to be a lot more consistency.”
Fisk said none of those choices are right or wrong, or even particularly hard — but however a bank chooses to navigate the probable demise of Libor, it needs a plan. And without a plan in place, a bank could find itself playing catch-up.
“I think this does have the potential to be substantially more complicated, and has the risk … of the player left behind,” Fisk said. “But if you thought about it like Y2K, ultimately those changes were made and that was a successful transition. If the focus is on preparing and having those conversations and working through all these issues, it’s a very doable event.”