LIBOR has been in use for decades in the capital markets and in Main Street lending, so naturally it’s been difficult to extricate. In fact, a progress report on the transition from LIBOR showed that the use of LIBOR has increased since 2018, with $223 trillion in outstanding contracts. The uptick prompted Federal Reserve Governor Randal Quarles, a former banker, to state, “It is finally time for everyone to actively transition away from using LIBOR.”
Quarles made it clear: Capital market participants must stop using the LIBOR interest rate benchmark for issuing loans and securities. Continuing to use the rate in new contracts after this year “would create safety and soundness risks, and we will examine bank practices accordingly,” he said. Regulatory guidance codifying this statement was issued soon after and banks and financial institutions have gotten the message.
Most banks, including my employer Brookline Bancorp, started planning for this eventuality in earnest three to five years ago. As a mid-sized commercial bank focused in Eastern Massachusetts and Rhode Island, approximately $2 billion of our loan portfolio was tied to LIBOR across 500 different relationships. That represents about 20 percent of our loan book, with further typical exposure across borrowings, deposits, capital and other items. The strategy for the transition has been similar to the preparation for Y2K: So far it is going smoothly, but not without an enormous amount of planning and cross-departmental teamwork.
Which Benchmarks to Pick?
Choice of benchmarks is essential to the successful transition from LIBOR. The world of new benchmarks will be much more transparent, efficient and more reflective of the actual costs of transactions than its predecessor. The Secured Overnight Financing Rate, or SOFR is based on daily secured transactions in the U.S. Treasury repurchase market, where investors offer banks overnight loans backed by their U.S. Treasury assets. There are also unsecured rates like AMERIBOR, which is based on daily transactions on the American Financial Exchange, a peer-to- peer lending exchange.
Choosing an alternative to LIBOR for new production and legacy contracts is all about aligning customer’s needs and the institution’s needs, along with market conventions. With more choice, we are able to meet all the different constituent counterparties requirements. In my opinion, SOFR is best for large institutions that borrow on the overnight repo market to hedge their financial position. SOFR is not a great option as an index for commercial loans given it is a “risk-free” rate. When you are lending to a commercial customer, 99 times out of 100, the relationship is not secured with Treasuries. In addition, SOFR’s underlying transactions are dominated by the largest banks and broker-dealers many of which were responsible for the LIBOR scandal uncovered in 2012. These factors combined result in SOFR being inappropriate for Main Street lending.
A credit component in an index is important to our institution because our funding is generally unsecured; some term, some overnight. A benchmark based on unsecured, multilateral lending activity, like AMERIBOR, better represents the nature of our cost of funds, whether it is in the deposit market, the cash market, or issuing sub-debt. Using AMERIBOR as an index for lending minimizes the mismatch with our funding base.
Does Blockchain Have a Role?
As founding members of the American Financial Exchange and minority owners, we appreciate the way blockchain technology and peer-to-peer borrowing capabilities have democratized the lending market for institutions like ours. In the past, when we wanted to borrow in the federal funds market, we would have relied on primary dealers or federal fund aggregators who would charge substantially more than the target rate. The American Financial Exchange peer- to-peer lending network has reduced overnight borrowing costs significantly for thousands of participating banks across America and as a result has created a market providing another choice to replace LIBOR that is not dominated by a handful of players. It is one example of how this competitive market fosters innovation as different index providers seek to meet different market needs.
For skeptical bankers, we have chosen to lead with the credit-sensitive AMERIBOR rate for new products historically tied to LIBOR, and you can too. Regulators have made clear that banks are free to choose their own LIBOR alternatives, as long as the alternatives are transparent and robust and meet IOSCO international principles for financial benchmarks and lending contracts contain fallback language to accommodate the wind-down of LIBOR
It will be a challenging year for bankers but remember keep an eye on the endgame: LIBOR’s demise is an opportunity to create successors with greater transparency and that promote the stability of our global capital markets.
Reed Whitman is the senior vice president and treasurer at Brookline Bancorp, the parent company of Brookline Bank.