Main Street takes issue with Wall Street’s LIBOR replacement

The use of a historic benchmark is coming to an end, but smaller banks argue its proposed replacement doesn’t meet their needs.

It wouldn’t be the first time that big banks and the Federal Reserve exerted outsized influence on an issue of great importance to the entire banking industry, but that’s what has occurred as the financial industry prepares for one of its most widely used benchmarks, the London Interbank Offered Rate, to go not so gently into the night at the end of the year.

The trouble is that while primary dealers and other large participants – those who trade Treasury securities for cash overnight in the so-called repo market – seem content to adopt the Secured Overnight Financing Rate to replace LIBOR because they operate in that market, the new rate falls far short of meeting the needs of Main Street banks. Indeed, the Alternative Reference Rates Committee, or ARRC, a panel including primary dealers that was convened by the Fed to ensure a smooth transition from LIBOR, recommends SOFR as the preferred replacement rate for everyone.

Community banks have several concerns with SOFR. For one thing, it is currently only an overnight rate, which doesn’t yet address banks’ needs for one and three-month options, like those of LIBOR. The term rates allow for a measure of predictability for borrowers and lenders. Although the Chicago Mercantile Exchange in April started publishing term SOFR reference rates, they are based on a futures market that isn’t very liquid.

The second issue is that SOFR is a secured rate, backed by US Treasuries. Because smaller banks typically lack large holdings of government securities, they usually obtain funding from sources other than the repo market. As a letter sent to regulators in February by 10 mid-size US banks stated, the collateral issue “presents an immediate asset-liability imbalance and potentially creates distortions in times of financial stress”.

The powers that be are quick to reassure participants that SOFR is only a recommended rate, and one that is intended to prevent the courts from being overrun with litigation over contracts where no replacement has been designated or where the parties can’t agree. But the smaller banks are worried that the imprimatur of federal regulators could have a chilling effect on the use of rates that more closely reflect their unsecured financing needs.

Already, New York and Alabama have passed laws requiring legacy contracts that are tied to LIBOR without a fallback rate to use SOFR, and a House committee is discussing legislation similar to that of New York to avert a wave of litigation. Fed chairman Jerome Powell has backed the idea of federal legislation. The controversy could rumble on for a while yet.

Write to the author at robin.b@peimedia.com