By Richard L. Sandor
In the U.S. and the U.K., the regulators have been clear: don’t expect the London Interbank Offer Rate to remain the dominant benchmark in financial markets. As its preferred replacement, the Federal Reserve has developed the Secured Overnight Financing Rate, which is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. Banks and other players in the global financial markets have three years to make the transition from Libor to one or more of the several alternative benchmark rates being developed or transacted on multiple exchanges around the world.
The encroaching deadline is causing concern among some market participants, but it need not. It’s been my experience that broad-based adoption of tools and technology can take a decade or more. We are now at a tipping point, but I believe the likely loss of Libor’s pre-eminence is more an opportunity than a challenge. We have multiple rates emerging to better serve specific segments of the market. The emerging replacement rates are based on actual trades and are better suited to different segments of the marketplace. Libor itself has undergone technical improvements aimed at correcting its past shortcomings.
So, what can bankers and their affiliates do to prepare for the transition?
- First, to mitigate the risks of transition, an institution must understand its current risk profile. How much is tied to Libor and how much expires before and beyond 2021? What alternatives can be considered? From an asset/liability point of view, which can prevent imbalances? Regulators will be watching for more disclosure and preparedness on these issues.
- Second are educational challenges. The use of new benchmarks will require educating loan officers, staff and customers. Many people may not even know that their mortgage, car loans or credit cards are tied to Libor.
- Along with recordkeeping, education and transitioning to a new rate or rates, a bank needs to select the right rate. A new rate must perform an asset/liability function. Does it accurately represent the cost of borrowing for an institution? If the chosen rate creates asset-liability mismatches, it obviously increases operational and financial risks for the bank. Boards, risk committees and ALCOs must be prepared to address these issues.
- Finally, the transition to new benchmarks (and the creation of new markets that comes with it) will require building institutional infrastructure. That means that not only bankers and regulators need to be involved, but also accountants, lawyers and academics. Academics can help provide the research and the training required to help a new generation of professionals understand the changes and new option.
The number of conferences, workshops and white papers concerned with the transition away from Libor is increasing dramatically. Interest in them is likely to grow as we move closer to the transition date. Banking, insurance and mortgage trade associations and others who depend on floating rates can play an important role in educating market participants and resolving common problems and challenges the industry faces.
We have every reason to believe that the U.S. financial sector—the most developed, flexible and innovative in the world—will maintain an orderly and smooth transition to new interest rate benchmarks. Industry groups are organizing to educate stakeholders. There are contracts currently being traded on organized exchanges (with other being planned for 2019), which will provide greater transparency and price discovery. That will speed up adoption.
The transition will cause short-term pain, but the payoff will be greater choice for banks and other financial institutions. When it comes to alternative rates, choice is critical. It enables participants to pick the appropriate rate for their circumstances and helps lower systemic risk. In times of crisis, it is better to have a choice of rates than a single benchmark. A rate like SOFR caters to bigger players, while the American Interbank Offered Rate, or Ameribor, an unsecured rate derived from transactions on the American Financial Exchange, is designed for and used by regional, midsize and community banks and other financial institutions.
I urge banks to take the long view. I started working on interest rate futures in 1969, and we launched the first futures six years later. It took a decade, and the Volcker tightening in late 1979, for them to take off. Likewise in this scenario, there’s time for banks and everyone involved to prepare and benefit from better choices ahead.
Richard Sandor is the Aaron Director Lecturer in Law and Economics at the University of Chicago Law School. He is also chairman and CEO of the American Financial Exchange, an electronic exchange for direct interbank/financial institution lending and borrowing.
