Just a few short years ago, banking experts encouraged community banks to tie variable rate loans to LIBOR. They said the switch would help smaller banks compete with big banks, while reducing their basis risk, operational overhead, and more.
Now with LIBOR facing its probable demise in 2021, many of these same experts are encouraging community banks to avoid writing any new loans using LIBOR. In other words, start reducing the LIBOR-based loans in your portfolio now so when LIBOR goes away, you’ll have fewer operational and customer communication burdens.
Whether or not you heed the advice to immediately avoid LIBOR is up to you. However, you should be proactive in discussing what you will do when LIBOR goes away. In a recent American Banker article, John Fisk, chief executive of the Office of Finance for the Federal Home Loan Banks, said it’s imperative that banks assess their vulnerabilities now and plan how they will navigate them.
Adam Gilbert, global regulatory leader at PwC, told Compliance Week that companies using LIBOR should engage corporate support functions like finance, controllers, and risk managers to perform an impact analysis and identify how to proceed. Communication with investors, clients, and customers may be critical, and some companies may want to work with industry peers or regulators.
SOFR as the Replacement?
In June 2017, SOFR was chosen as the replacement for USD LIBOR by the Alternative Reference Rates Committee (ARRC). SOFR is based on the overnight interest rate received for lending cash against US Treasury securities. These debts are backed by the collateral of Treasuries, making SOFR a secured rate. SOFR is already being used in futures and overnight index swaps, and in some corporate debt.
SOFR’s reliance on Treasuries revealed a potential vulnerability in December 2018 when rates on overnight treasury repurchase agreements pushed the benchmark higher by almost 70 basis points over two days. This was concerning, and some finance experts are forecasting additional volatility as the US struggles with the reintroduction of the debt ceiling.
No doubt the Fed and ARRC will be closely monitoring this issue.
Is SOFR for You?
Ultimately, the reference rate or rates you choose depend on the factors unique to your institution, including your cost of funds, lending niche, and loan-pricing methodology. It will also be influenced by what your competitors are doing.
If you’d like to discuss this topic with the Dashboard team, please contact us.