Commercial Banking's Looming LIBOR Problem

Amidst all the challenges facing commercial banks during the pandemic, there also looms a problem on the approaching horizon - can they meet regulators' deadline to switch from LIBOR to SOFR?

In this episode of The Purposeful Banker, we take a look at the issues involved, debate whether the deadline is realistic, and consider potential solutions for commercial banks. 




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Jim Young: Hi and welcome to the Purposeful Banker, the podcast brought to you by Precision Lender. We discussed the big topics on the minds of today's best bankers. I'm your host, Jim Young, Director of Content at Precision Lender, and I'm joined again today by Dallas Wells, our EVP of Strategy.
Before we start let's go behind the curtains, again, shall we? A couple of weeks ago, when we were getting ready to record our podcast on CECL, I got a chat message from Dallas that, I'm going to paraphrase here, basically said, "Do we really have to do this?" So obviously Dallas is the talent, so sometimes you have to get used to dealing with the diva situations here. I patiently explained why I thought that a podcast on CECL was relevant, assured him we would not go too deep into accounting minutia. Fast forward to this morning when Dallas sends over a Wall Street Journal article titled LIBOR Pains Deepen As Deadline for Benchmarks Demise Approaches, and suggests that we do that as a podcast topic. It's not hard to connect the dots here.
This is obviously retaliation from Dallas on this. He has called my CECL podcast and raised it with a LIBOR/SOFR podcast. But I'm a true professional, so even though LIBOR conversations, honestly make me want to break out in hives, we're going to do this because just as with CECL before, this is a very relevant topic right now. So, Dallas, did I basically capture the backstory of this pretty accurately?
Dallas Wells: I think you got it perfectly, and so this one is nothing but retaliation for last time.
Jim Young: It was just funny as I was doing the research and I was like, "God, LIBOR again!" And I'm like, "This must be exactly what Dallas was thinking when I said, 'Hey. Let's do a podcast on CECL'."
Dallas Wells: Yep. Now we're even.
Jim Young: All right. Now that I'm done whining, we can start the conversation. So, Dallas, I got to admit, again, also when you sent this over, I felt like LIBOR transition talk was like someone coming around to your cubicle and asking you if you've stapled the cover sheet on your TPS reports when you're in the middle of a work emergency. It feels like there's so much going on in banking at the moment. Should we really be worried about this change that's still over a year away?
Dallas Wells: That's a fair question because it's the same one I've asked a couple times over the last month or two. So we've been in conversations with a whole lot of banks over the last few weeks, and we are assuming that they will want to talk about non-performing loans and all the things that need to be done and steps that needed to be put in place, and for a fair number of the banks, that is the case. That's top of mind, and it's what needs to be dealt with. For a surprising number, they don't want to talk about that at all because they want to talk about SOFR. So we had a couple folks on our sales team asked me, "Hey. Do we have any materials on how we handle SOFR? I've got a bank that that's all I wanted to talk about in the last meeting."
I'm like, "SOFR. This is not complicated. Of course we can handle it. Here's a support article that shows you how to do it." You literally just change the index rate in the system from LIBOR to SOFR. It's a four second process. I don't understand why this took meeting time. So this happened more than once, and I figured out that it wasn't our sales team or the banks that were the idiot, it was me not really grasping the degree of complexity here. So this one's a strange one in that for the index to go away, there's a sunset date sitting out there on LIBOR.
So what's happening is banks are now booking transactions that have terms that go out past that sunset time. So even though it's a couple of years into the future, there's deals that are being booked literally today that are referencing LIBOR, that before the end of that contract LIBOR will cease to exist in its current form.
And so there's a whole bunch of operations folks at the bank saying, "wait. You can't do that." You can't reference a rate that we know is going to go away. The bankers booking the deals are like, "Come on. It's LIBOR. Everybody uses LIBOR for everything." So until I'm told, I'm not allowed to, that's what the deal is. So the marketplace and the accounting and the operations and the market folks are all disagreeing on what the right timeline is here and what the right steps are, and as you dig into it, it's really complex. There's a lot of people and systems issues that need to be dealt with, so it's a bigger deal than I thought, and I stand corrected, and so here we are. We are talking about it today.
Jim Young: Alrighty. Okay. So this is the part where I really got frightened here because we start talking about derivatives and that's when I really feel like I'm out of my depth here. But they just noted that, "Hey. $3.4 trillion worth of business loans are tied to a LIBOR and $190 trillion of interest rate derivatives are tied to the rate." And I guess I was like, we tend to talk about things in terms of commercial lending and commercial loans and those sort of things. That's that feels almost like it's collateral damage in all of this. Is that fair to say?
Dallas Wells: Well, derivatives will get a lot of the attention when it comes to LIBOR because of that big nominal number there. It's huge. The issue with derivatives is that there's always two sides to a contract and you'll actually see a bank for one piece of exposure, sometimes they will have three or four or five different contracts where they're offsetting different pieces of that risk, so you may have a $1 trillion loan that turns into $5 trillion, a trillion dollars of the loans that turns into $5 trillion worth of derivatives that are tied to those same instruments. And so some of that is double, triple counting. There's not real exposure there. Those are offsetting things. And a lot of times to hedge an exposure, you don't cancel the existing derivative. You just take the opposite exposure. So as banks move back and forth in the risks that they need to hedge, they just keep layering dollars on top.
I guess that's a way of saying, it seems worse than it is, but that's still $190 trillion worth of contracts that have to be settled. So each one of those, even if they're offsetting risk, that is a free standing instrument that somebody is going to have to figure out how to settle the interest accruals and what index to fall back on when LIBOR goes away, and we transitioned to whatever plan B is. And this is where things get really messy, and why banks are starting to worry about this. Plan B it needs to be the same for all of those instruments or they're not really offsetting risks.
Then you have basis risk and you have different things going different directions, and that's why you have risk management folks at the bank starting to panic a little bit is because those things are no longer perfect hedges or offsets for each other. So those are all related issues. The things going on in the derivatives market are the same sorts of problems that have to be solved in the loan market. And I know it seems small in comparison, but $3.4 trillion is not chump change.
Jim Young: True.
Dallas Wells: It's still real things to be done there in the loan market as well.
Jim Young: So the plan, you mentioned plan B, the plan for the fallback or the switch was to go from LIBOR to SOFR, as we all know. And one of the big criticisms of LIBOR was its volatility, but I just want to run these three dates by you here. And now granted, I'll grant you, this is right at the point where there was the big rate cuts, so March 16th, SOFR plummets down to 0.26%. Okay. Bu everything plummeted that day, so that's understandable. The next day, SOFR shot back up to 0.54%, doubled in a day, and then the following day, it plummeted down to 0.1%. Again, I am not the banker here, but that does not sound like a very stable index. So tell me why is that a better alternative than the volatility of LIBOR?
Dallas Wells: Well, it's not better is the short answer, and I think they, the more complex thing here is that for LIBOR it's been the market standard for long enough that there's some established practices here. So as you're out trading these instruments or things are being referenced against them. A lot of times there's some smoothing mechanisms in place there, so you use a seven day average or a 30-day average of that index, so it removes some of that noise as instruments get repriced. And it's expected that those things will develop for SOFR as well once it's a deeper market. Right now, there's just not enough. It's too shallow. There's not enough transactions happening for those standards to become a norm so I don't think SOFR necessarily solves any of the volatility, the theory is is that SOFR removes some of the credit risk that LIBOR had implied in it.
So LIBOR was a rate at which banks exchanged credit with each other. And so it wasn't just the rate market being captured there, but it was also some of the credit risks between those banks because these were basically unsecured overnight loans to each other. And so if one bank was a credit risk then, or if just there was uncertainty in the bank market in general, you would see big spikes in LIBOR. It happened during the financial crisis to the tune of six or 700 basis points in a day's time where it was just wild swings in that index. SOFR's had some of the same noise now, even though some of that credit risk is not supposed to be there. There's a difference between secured versus unsecured, and so that's supposed to remove some of the credit risk, but that's the theory.
The evidence is is that we haven't seen that actually happen yet. So we'll see, but markets have a tendency to do what they're going to do. Right? So, theory be damned. There's going to be some volatility here in the markets. We'll have to figure out how to handle that through some sort of smoothing. Those are just the painful parts of the transition that banks are dreading. And as you said at the beginning here, it's a couple of other things going on at the moment. So it's tough to get all these things done in the right timeframe.
Jim Young: All right. So, again, and we've seen this right now. If I'm a customer and I've got a loan and something like a pandemic happens and stuff is happening, and then I go to my bank, can we talk about maybe some forbearance. Right? Give me a little bit of time to sort this other stuff out, and then we'll get back to our relationship and everything we'll move on. Can we have some LIBOR forbearance? Can banks basically say like, "Hey. Listen. We were all set to do this by your 2021 deadline, but a little thing called COVID-19 has happened. Can we push this deadline back?"
Does that make sense? Or are you kicking the can down the road, and there'll be something else in 2021, not God-willing this, but something else that will make people say we can't do it now? And I guess my other question is, is, are there banks out there who have already really gone through the pain, who may be saying, "No. Wait a second. We did this in good faith saying 2021 was the deadline. So you can't push that back. That's not fair to us?"
Dallas Wells: I think the only evidence we have to go on here is what happened with the Main Street Lending program. So when that was first rolled out, this felt like the shot across the bow from the Fed, because they said these deals are going to be priced on SOFR. And it was like them drawing the line in the sand of, "Hey. We're here to help. We're backstopping the market. We're going to do this unprecedented direct lending, not direct, but pretty darn close to direct to business lending from the Fed. But if you want to play, you got to use SOFR." I think it was between the regulator and the banks seeing who was going to blink first and the Fed blinked, so that got changed to LIBOR, and the response from the banks when that first came out was, "Hey. We'd love to use Main Street, but we literally can't if it has to use SOFR."
And there are some systems accounting issues that I don't understand well enough to go into, but basically it's how you accrue interest between SOFR versus LIBOR, where a lot of banks' existing core general ledger systems actually can not handle SOFR. It's not just like, "Hey. We got to wait for the vendor to do an upgrade." It's just like it just literally can't handle it.
So this is not a simple solution. I don't think it's a 2021 kind of solution. So my guess is, and this is just Dallas' guess, this is no inside information, obviously, and no deep research into it, but it feels like there may be a delay to this, but if you're a bank who's doing many billions of dollars of transactions in these, can you really afford to call that bluff? I don't think you can.
So I think banks have to keep making progress on this. I just don't know if they can make that deadline.
And, again, there are transactions being booked today that go beyond that sunset, that are using LIBOR and don't have a great backup plan in the loan docs, or in the contract language. So it feels like this is already, the problem's already out, it's already out there in the wild. And so there will have to be, at very minimum, if not a delay, at least some forgiveness in how those things are settled out with regulators, and this goes across borders.
It's really complicated. This is a global issue, that there's a handful of global banks that play in all those markets, but for the most part, it's a lot of different sovereign regulators trying to work together to figure out what the right answer is here. And I just don't think we can make that deadline.
Jim Young: Alrighty. And just to add another layer of complication to that, let's throw in Ameribor, as well, which apparently some smaller banks prefer, and I will have to say that when I was looking at the volatility charts with SOFR, while SOFR went shot up and then back down, and it looked like an EKG, Ameribor went down with everything, but then it was pretty stable. Can you, I don't know, 250 words or less, give me Ameribor versus LIBOR versus SOFR? Tale of the tape? 
Dallas Wells: Oh. Gosh. The Twitter version. Yeah. The Twitter version comparison there. So this decision is being made by something called the ARC committee. I'll get the acronym close. It's like the alternative reference rate committee, something like that, but this is basically the New York Fed and some of the biggest banks in the world are part of this committee.
So what some of the smaller banks are saying is, "Hey. We all saw what happened with LIBOR, which is basically the same kind of setup." The biggest banks in the world posted what their transactions were. And then they realized somewhere along the way that they could rig those markets and set the rate and then make money because they knew what the rate was going to be. They've tried to, in the structure of this correct for some of that, but it is still about eight banks that ended up setting what the SOFR rates are.
They're the primary dealers of the Fed. They're the ones that actually functionally operate this market and they get to set the rate. And so what some of the smaller banks were saying, is this rhymes an awful lot with the last story. So SOFR just feels like a slightly better version of LIBOR and we're right back where we started, and we think Ameribor is superior. And the ARC committee, which is again made up of primarily those big banks that are going to be a part of it, have said actually we like SOFR better.
This is one of those big banks versus small bank disagreements. I don't know if there's a better answer between the two, but just based on where all the volume of this market actually happens and who actually operates the rails for it feels like it's forgone conclusion that it's going to be SOFR and there'll be some grumbling and complaining about it, but I think that ship has sailed.
Jim Young: Okay. Another possibly dumb non-banker question coming in on this, but can we talk about now people pricing prime versus LIBOR, could you going forward just say, "You know what? I'm not going to do SOFR. I'll just do Ameribor."
Dallas Wells: You can. Again, the reason for this standard number is for the same reason that the derivatives market ends up being driven by LIBOR. It becomes a global standard and it becomes one known index with similar terms, similar language, similar ways of settling, days from settlement when cash is exchanged. These markets become really standardized and that's why they work as well as they do. They're deep and they're liquid and they're transparent. And so it's going to be a thing where if you want to play in that deep liquid market, so for example, in swaps, if you want the best swap pricing right now, you use LIBOR. You can do prime swaps, but it's not the same depth of market. You don't get as many term choices. You don't get as good a pricing. I'm guessing Ameribor or other future alternatives will be the same way. SOFR will be the biggest game in town. It'll be where you have the most options, the most liquidity, and if you really just want to, out of principle, use something different, you can, but you have to pay for it.
Jim Young: Okay. Gotcha. All right. Well, this article basically lays out the list of issues - "Hey. This could be a problem. This could be a problem. This could be a problem. This could be a problem." What it doesn't really have is someone saying, "Hey. This is what should be done to solve that problem." So Dallas, this podcast topic was your idea. So what do you think should be done?
Dallas Wells: Okay. Turnabout is fair play there, I guess. So I think all that banks can do, this is a thorny problem. You know, we've just touched on a few of the issues here, but basically it comes down to a combination of three things.
There are issues with getting to this new standard in the marketplace so it's a big transformational change from one index to another that is in a multi trillion dollar market is just a big deal. There's so many players involved and so many standards that have to make that transition.
The second one is the systems. LIBOR touches dozens, in big banks maybe hundreds, of software systems where it might be simple for one system like Precision Lender. It's pretty easy for us. For some like the core, general ledger accounting system, it's a much more painful thing. And now those systems all have to speak to each other in the same language about SOFR, and which term, once there are eventually term structures for SOFR. Those things all have to yet be worked out.
The final one is the one that I think bankers can start dealing with right now. And that's what we've been talking to a lot of our clients and prospects about it. And that's the people part of this, the change management.
For example, as banks are pricing deals right now that go beyond that sunset window, ideally they should be pricing that against SOFR. There is enough of a market out there that they can do that. And that just removes one known hiccup from the loan docs that they can just get dealt with right now. But it's really hard to get bankers to do that, to say, "Hey. This one meets the criteria, quote it in SOFR instead of LIBOR." And if it was in LIBOR, what's the equivalent rate in SOFR?
Some of that change management of just making sure that your bankers are all aware of what do you expect, how do they translate one rate to the other? As you're doing a deal for a customer, maybe you should look at their other five deals, and if you need to rewrite those to the new index while you're doing that one new one, those are your opportunities to do that where it's going to be most efficient. You're actually going to get a response from them. It's going to be the cheapest way to do it, but those things need to be happening right now.
And so those are the things that the banks can do to prepare as the rest of those things get sorted out between systems and the markets. Those will just take some time. And as we said, there may be an extension on that. But regardless, the sooner you can get some of the behavior changes done with your frontline bankers, those are the things that you can start on right now. And, again, those are not easy, but those are the ones that you can start right now and actually make some progress with.
Jim Young: Yeah. Well, I mean, I hope that's the case and I hope that we're not, I don't know, 12 months from now doing a podcast on LIBOR transition is three months away. Are banks anywhere close to having this solved?
Dallas Wells: That kinda looks like how we're headed.
Jim Young: Yeah.
Dallas Wells: But yeah. Hopefully there's at least some clarity that comes into this over the next few months.
Jim Young: All right. Well, that'll do it for this week's show. Dallas, thanks again for coming on.
Dallas Wells: You bet. Thanks, Jim.
Jim Young: Thanks so much for listening and now for a few friendly reminders. If you want to listen to more podcasts or check out more of our content, visit our resource page at Precision Lender dot com or head over to our homepage to learn more about the company behind the content. You like what you've been hearing, please make sure to subscribe to the feed and Apple podcast, Google play, or Stitcher. Love to get ratings and feedback on any of those platforms. Until next time, this is Jim Young and Dallas Wells, and you've been listening to Purposeful Banker.

About the Author

Jim Young

Jim Young, Director of Content at PrecisionLender, is an award-winning writer with experience in a range of positions in media and marketing, from reporter to website editor to content marketer. Throughout his career Jim has focused on the story – how to find it, how to understand it, and how best to share it with others. At PrecisionLender, he manages the many ways in which the company shares its philosophy on banking and the power of relationships. Jim graduated Phi Beta Kappa from Duke University and holds a masters degree in journalism from Columbia University.

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