The NAFCU Journal: Cutting the Cord with LIBOR

By Curt Long

Credit unions have plenty on their plates these days. An inverted yield curve and slowing economic growth threaten profitability in the near term. Meanwhile, planning for the approaching changes to credit loss reporting standards and capital requirements are causing headaches. In addition, credit unions must give due consideration to the rise of fintech and to their own long-term competitiveness. One issue that may have been lost in the crowd — but is deserving of their full attention — is LIBOR transition. Cutting the cord with LIBOR

Background on LIBOR

The London Interbank Offered Rate (LIBOR) is essentially the rate at which banks make short-term loans to one another. The rate itself is constructed from a survey of a panel of banks on what that rate would be. LIBOR became the standard rate included in derivatives contracts, and so it grew in prominence as the derivatives market exploded in the 2000s.

Today, it is estimated that LIBOR is the reference rate for a staggering $200 trillion of financial contracts. The vast majority of those (around 95 percent) are derivatives. Only a sliver is in the form of consumer products, but that total is still estimated to be $1.3 trillion.

The Trouble With LIBOR

Following the financial crisis, regulators imposed heightened capital and liquidity requirements on banks. As a result, the types of transactions that form the foundation for LIBOR — short-term interbank loans — occurred less frequently. The quoted rate became more dependent on the judgment of those panel banks.

The system was ripe for manipulation. Investigations began in 2010; lawsuits, hefty fines and a criminal conviction followed. It was clear that LIBOR’s reputation had been irreparably damaged. Moreover, the panel of banks submit-ting estimates to form the rate was understandably reluctant to continue doing so. Although the governing body overseeing LIBOR has commitments from the panel of banks through the end of 2021, it will not compel those banks to take part thereafter.

Enter SOFR

With the fate of LIBOR very much in question, stakeholders began to consider alternatives. Under the direction of the Federal Reserve Bank of New York, the Alternative Reference Rate Committee (ARRC) convened in 2014 to identify an alternate reference rate and to facilitate transitioning away from LIBOR.

Their solution was dubbed the Secured Overnight Financing Rate or SOFR, and it differs from LIBOR in some key ways. It is a reference rate relying entirely on transactions in the overnight Treasury repurchase market, which is a much more substantial one than that used for LIBOR. Because these transactions are secured by U.S. Treasurys, there is negligible credit risk baked into the rate, which is not the case with LIBOR. Finally, where LIBOR is quoted across seven different maturities spanning from an overnight rate up to one year, SOFR is based only on a single (overnight) maturity.

Adoption of SOFR

In spite of the broad agreement around moving on from LIBOR, actually doing so has proven challenging. The New York Fed began publishing SOFR in spring 2018. One year in, SOFR-issued securities totaled just over $100 billion, compared to more than $900 billion of LIBOR issuances during that time.

The largest inherent challenge is the lack of term structure. However, some progress has been made. Recently, two Federal Reserve economists formed for-ward-looking rates using SOFR futures. The hope is that the ARRC will settle on this or some other alternative as a preferred term structure for SOFR.

Preparing for the End

Given the immense uncertainty around LIBOR after 2021, credit unions would do well to assume that it will cease to continue. The first order of business is to review existing contracts to determine exposure. Fallback language for consumer loans varies, but it generally allows the noteholder to name a successor rate. However, many contracts are unclear about whether the rate spread could be adjusted following a move to a successor rate. In effect, this would make the loan rate fixed.

For new adjustable-rate loans, it is imperative to either use SOFR or some other reference rate or makes sure the fallback language is clear in the event LIBOR ceases to continue after 2021. There should also be clarity around the trigger for the selection of a new reference rate. LIBOR may continue to be quoted after that date, but it may no longer serve as a useful reference.

Finally, IT systems may need to be updated to incorporate a new reference rate and to facilitate the transition in 2022. Credit unions would also be advised to begin thinking about how they will communicate these changes to their members.

In July, Federal Reserve Bank of New York President John Williams expressed concern over what he sees as a lack of urgency in adopting SOFR. The month prior, Fed Vice Chair of Supervision Randal Quarles said of the move away from LIBOR that “beginning that transition now would be consistent with prudent risk management,” and that there will be supervisory expectation of progress on that front. As we draw nearer to 2022, regulatory scrutiny of LIBOR contracts will only increase.

Curt Long is NAFCU’s chief economist and vice president of research.

This article was published in the September-October 2019 edition of The NAFCU Journal magazine.
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