By Richard Sandor
The most influential and discredited number in modern finance began its disappearing act from the global capital markets at the end of December 2021. Given Libor’s dominant role as an interest rate benchmark since the 1970s, the fact there was little disruption speaks volumes about the resiliency and innovation taking place in our financial system.
There are still issues that need to be addressed, though, such as legacy contracts tied to Libor that lack fallback language for alternative benchmarks. But in general banks and other financial services firms have been preparing for the change for years and most certainly will benefit from multiple benchmarks to choose from.
For example, Brookline Bancorp started planning for this eventuality in earnest three to five years ago. As a midsize commercial bank in eastern Massachusetts and Rhode Island, Brookline had approximately $2 billion of its loan portfolio tied to Libor across 500 different relationships—roughly 20 percent of its loan book, with further typical exposure across borrowings, deposits, capital and other banking activities. The build-up for the transition has been similar to the preparation for Y2K, which required extensive planning and cross-department teamwork to avoid any business disruption for customers and the bank.
Choice of benchmarks is essential to the successful transition from Libor. “A banking industry that is so varied, so complex and so essential to the American economy needs the diversity and durability that comes from choice in interest rate benchmarks,” former Commodity and Futures Trading Commission Chairman Christopher Giancarlo testified in November before the Senate Banking Committee. “A one-size-fits-all response to the demise of Libor would be a source of systemic risk to the U.S. economy. As we rightfully move away from Libor, we should make clear that lending institutions—be they money center banks or local, regional or MDI banks—should have the flexibility to choose among International Organization of Securities Commissions-compliant benchmark alternatives that best meet both their lending activity and their customers’ needs.”
Midsize banks have gone on the record saying that a credit component in an index is important to their institutions because their funding is generally unsecured, which includes some term and some overnight transactions. A benchmark based on unsecured, multilateral lending activity—like Ameribor, which is published by the American Financial Exchange, which I founded—better represents the nature of cost of funds, whether it is in the deposit market, the cash market or issuing subordinated debt. They added that using Ameribor as an index for lending minimizes the mismatch with the bank’s funding base.
Choosing an alternative to Libor for new production and legacy contracts is about aligning customer’s needs and the institution’s needs, along with market conventions. With more choice, banks are able to meet all the different constituent counterparties’ requirements.
A plug-and-play alternative to Libor is easy for bankers to understand and explain to bank customers on the regional and community bank level. These are the businesses that drive the U.S. economy and deserve choice in borrowing options.
Having choice among multiple qualified benchmarks will facilitate the transition away from Libor, enhance efficiency and reduce systemic risk. The Secured Overnight Financing Rate has an important place in the efficient functioning of the repo market, on which SOFR is based, especially in times of record deficit and debt levels. But for many smaller banks, having a credit-sensitive component that reflects their cost of borrowing is a matter of survival. They need a rate that reflects their credit risk, which is higher than the bigger banks.
Richard L. Sandor is the Aaron Director Lecturer in law and economics at the University of Chicago Law School. He is also chair and CEO of the American Financial Exchange, an electronic exchange for direct interbank/financial institution lending and borrowing that publishes the Ameribor rate.
