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Home Commercial Lending

The Replacements

November 19, 2018
Reading Time: 4 mins read

By Evan Sparks

Libor—the London Interbank Offered Rate—is perhaps the liveliest dead man walking. It underpins more than $350 trillion in mortgages, commercial loans, bonds and derivatives worldwide; U.S. dollar Libor alone is the reference rate for $200 trillion in financial instruments.

And yet virtually everyone in the financial sector acknowledges that Libor’s days are numbered. The British Financial Conduct Authority has said Libor will be sustained through 2021, but its lack of depth and transparency makes its long-term viability questionable. As the Alternative Reference Rates Committee has noted, “Libor is increasingly based on the expert judgment of panel banks [and is] increasingly less of a robust, transactions-based market interest rate as envisioned by international standards for benchmarks.” Two banks have stopped submitting transactions to U.S. dollar Libor, further weakening the rate.

For several years, U.S. financial institutions and regulators have been planning for a transition away from Libor. In 2018, the Federal Reserve began publishing three reference rates, including the Secured Overnight Funding Rate, which the ARRC recommended as a replacement for U.S. dollar Libor. SOFR is a broad measure of overnight Treasury financing transactions with about $700 billion in underlying transactions per day.

“There is space for many different kinds of reference rates,” says David Bowman, a special adviser to the Fed and an ex officio member of the ARRC. “The Fed is not saying that everyone has to trade SOFR, or that you can’t trade Libor—but if you want something that can replace Libor, it’s got to be the most robust thing you can find.” While SOFR is deep and robust—and Bowman admits it’s more of a capital markets measure—some banks are concerned that its secured nature will not reflect their true borrowing costs.

‘Reflective of our cost of funds’

One alternative to Libor and SOFR is a relatively new benchmark called Ameribor. Published by the American Financial Exchange, Ameribor reflects banks’ actual interbank borrowing costs based on overnight unsecured borrowing done through AFX’s online platform.

AFX is the brainchild of one of America’s most creative financial technology innovators, Richard Sandor—known as the “father of financial futures” for his work in the 1970s as chief economist at the Chicago Board of Trade. In late 2011, amid near-zero interest rates, he saw that there was no real interbank trading—but that would return once rates began to rise. He also foresaw that Libor would become unsustainable. “There would be a space for a market for interbank borrowing and lending to re-emerge,” he reflects. “Let’s make our audience regional and community banks.”

AFX opened in December 2015 with just four banks: MB Financial in Chicago, Associated Bank in Green Bay, Wis., Old National Bank in Evansville, Ind., and Frost Bank in San Antonio, Texas. “The four banks did not have credit lines to each other,” Sandor remembers. “That quickly changed.” The exchange handled $10 million that day. “We have created new lines of liquidity between banks that never had them.”

Today, AFX has 101 member institutions—mostly regional, midsize and community banks, with assets as small as $200 million—with several hundred different lines of credit between them and an average daily trading volume of more than $1 billion. Through its platform, AFX provides a fintech solution to help banks meet their overnight funding needs or provide overnight funding to peers more efficiently, but all of that unsecured lending fuels Ameribor—but instead of reflecting the interbank rates reported by bankers, as Libor does, it reflects what bankers actually paid through the trading platform.

“Regulation and transparency are critical to ensuring the integrity of a market,” says Sandor, who notes that AFX is a self-regulated exchange via a joint venture with the Chicago Board Options Exchange, with strong anti-manipulation rules. “We’re not doing anything that hasn’t been done before . . . we’re generating a market-based reference.”

Ameribor’s key difference from SOFR is the unsecured versus secured distinction. Sandor calls SOFR “a very good tool for the largest banks in the country” but doubts that regional and other banks will find their borrowing costs reflected in the new Fed rate. Ameribor tends to be roughly 15 basis points higher than both Libor and SOFR.

ServisFirst Bank—a Birmingham, Ala.-based bank with a commercial lending focus and $7 billion in assets—made waves in September when it made the first-ever loan that referenced Ameribor. The bank selected Ameribor for the loan because “it’s reflective of our cost of funds,” says Tom Broughton, ServisFirst’s president and CEO.

SOFR wouldn’t work as well for ServisFirst, Broughton adds. “It’s not an appropriate rate to tie a loan to because it’s a secured rate. I feel confident when we have times of stress, there will be a divergence between the cost of unsecured and secured rates.” He doesn’t expect any pushback from regulators, nor has he received any thus far.

Transitioning away from Libor

Regardless of which rate banks choose going forward, transition planning is key. The ARRC estimates that U.S. dollar Libor is referenced by $3.4 trillion in business loans and $1.3 trillion in mortgages and other consumer debt. “There are many places you could have Libor exposure,” notes Bowman.

More banks may make the switch to Ameribor as the transition looms. “We’re going to start transitioning clients slowly to Ameribor rate,” says Broughton. “As time goes on we’re going to be increasing the rate of transition.” He expects that 20 percent of new loan volume will reference Ameribor by year’s end.

The ARRC is focusing on contract robustness. Bowman points out that many commercial loans may revert to the higher prime rate for reference should Libor fail. “That would be good for banks, but you may have a bunch of angry customers screaming at you,” he says. “You want to work out with your customers what happens when Libor stops.”

Douglas Elliott, a partner at Oliver Wyman, adds that banks need to address inconsistencies in fallbank language across their contracts. He advises that banks have a senior executive responsible for the transition to emphasize the importance and scope of the project. “There is a need to rethink pricing, and possibly product design at some point,” says Elliott. “How often do we in the banking industry take 30-40 percent of our book and reprice it?”

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Tags: FintechLiborLiquidityMidsize banksReference ratesSmall business lending
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Evan Sparks

Evan Sparks

Evan Sparks is editor-in-chief of the ABA Banking Journal and senior vice president for member communications at the American Bankers Association.

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