With less than 100 days left before a key deadline, banks are moving away from the world’s most important interest rate more slowly than regulators had hoped.
Despite years of preparation and hand-wringing, many new U.S. bank loans are still using the London interbank offered rate, or Libor, which is being phased out globally after a rate manipulation scandal years ago.
The limited progress is “disappointing but not surprising” and reflects the massive challenge of moving lenders away from a benchmark they’ve used for decades, said Kathryn Judge, a law professor at Columbia University who focuses on financial stability.
It also sets bankers up for a potentially hectic close to the year as they work to explain the changes to commercial borrowers — some of which are less prepared than others — during loan negotiations. Regulators have stressed that banks should not make new Libor loans after Dec. 31 since doing so would “create safety and soundness risks.”
The Libor loans that banks are making today include fallback options in the event of Libor’s eventual demise, lessening the possibility of market disruption, and activity in non-Libor lending is set to pick up in the next few weeks.
But so far, banks have yet to lean into using non-Libor benchmarks — either the one that regulators have implicitly pushed or one of two competing rates that have gained some traction — when making loans.
The transition is happening more rapidly in the much larger derivatives market, where the U.S. version of Libor underpinned more than $200 trillion in contracts last year, compared with just $6 trillion in loans. Analysts say the derivatives market is increasingly adopting the Secured Overnight Financing Rate, or SOFR, the benchmark that a U.S. group of market participants convened by the Federal Reserve established in 2017 as a Libor replacement.
But banks have been hesitant to move away from their use of Libor in loan documents, even though regulators have been raising concerns for months about the pace of the transition.
“The deniers and the laggards are engaging in magical thinking. LIBOR is over,” Fed Vice Chair for Supervision Randal Quarles said in June.
Many banks declined to comment on their Libor transition plans for this story. Some said that they began making non-Libor loans months ago or will be ramping up that activity in the coming weeks.
The transition is set to accelerate — and soon. Many banks have established internal deadlines in October or November for their teams to move away from making Libor loans, according to bank executives and advisers who work with them.
Even so, some individual bankers and their business clients may not be responding with a sense of urgency, industry consultants and lawyers say.
Some larger businesses have followed the arcane details of the Libor transition closely, but other firms are only vaguely aware of it. Those companies’ internal finance systems may also not be ready for the transition.
“There’s a lot of operational complexity,” said Venetia Woo, principal director at the consulting firm Accenture. That’s true not just for financial institutions, but also for the treasurers at companies that borrow from banks, she added.
Tom Wipf, who chairs the committee that was convened by the Fed to plan for the Libor transition, said he’s long advised banks to “stop digging the hole” by adding to their Libor exposures. Still, new Libor loans have strong fallback language that will switch borrowers to a non-Libor rate when the soon-to-be-defunct benchmark goes away, he noted.
‘Inertia in the loan market’
Regulators have been expressing their concerns about the slow transition publicly in recent months.
Lending that relies on non-Libor benchmarks is “not where it should be at this point” due to “inertia in the loan market,” Michael Held, the Federal Reserve Bank of New York’s general counsel, said in a Sept. 15 speech. Treasury Secretary Janet Yellen said in June that business loans were “well behind” in transitioning away from Libor.
Dueling deadlines set by regulators have not helped, said Judge, the Columbia law professor. Regulators have made clear that banks cannot make new Libor loans after 2021, but they decided to let legacy contracts continue to refer to Libor until the middle of 2023 to make the transition smoother.
The latter deadline reduced the urgency at some businesses that thought they “were let off the hook” to quickly make the investments necessary to deal with the change, said Bradley Ziff, a senior advisor at the consulting firm Sia Partners who has surveyed dozens of banks about their Libor transitions.
Those borrowers’ understanding of the relevant deadlines has improved, but it slowed their progress “in a meaningful way,” he said.
Another source of confusion has been the existence of several options to replace Libor, according to Ziff.
U.S. regulators have long encouraged banks to transition to SOFR, which is based on transactions in the massive market for U.S. Treasury securities, rather than estimates from a limited set of major banks — a thin set of calculations that ultimately opened the door for Libor’s manipulation.
But banks can choose from a few SOFR flavors when making loans. There is also Ameribor, a benchmark from the American Financial Exchange that is preferred by some regional banks because it is tied to their actual borrowing costs. More recently, Bloomberg launched its own benchmark called BSBY, which has gained momentum among banks.
“The clients are saying: ‘Well, how do I know there’s not going to be another shoe to drop?’” Ziff said.
Banks’ management may also be in a somewhat different position than the commercial bankers who work on deals themselves. Banks’ relationship managers have been a bit reluctant to take non-LIBOR rates to clients, wary of any hiccups or legal action if they “accidentally mis-sell or mis-portray a product due to a lack of understanding,” Ziff said.
Some banks are further along than others. Cleveland-based KeyBank’s commercial real estate group started making SOFR-based loans last December, and the vast majority of its loans no longer use Libor, said Andrew Lucca, western regional manager for KeyBank Real Estate Capital.
“It was a slow process, but we did that because we wanted to not only get our clients comfortable with switching over, but our bankers as well,” he said. “Because when you're switching over from a rate that's been in existence for a long time, it takes time to work out the kinks.”
Truist Financial in Charlotte, North Carolina, began offering SOFR loans in October 2020 and this quarter rolled out other options, including Bloomberg’s BSBY rate. Regions Financial in Birmingham, Alabama, told clients earlier this year that it would stop issuing Libor loans after mid-September.
Phoenix-based Western Alliance Bank has been discouraging Libor lending since the middle part of the year, according to Treasurer John Radwanski, who said that much of the bank’s new lending no longer uses Libor.
‘It’s going to come fast’
One catalyst for change in the coming weeks will be banks’ efforts to start using a forward-looking SOFR option, which was not ready until late July, but which banks say is a far more workable option for loans.
Bankers had long criticized SOFR for lacking a forward-looking option, which would tell borrowers upfront the rate they would pay for the next month or more, much like they can get with one-month Libor options.
But regulators had nudged banks to adopt SOFR without waiting for the forward-looking option, known as “term SOFR,” which needed more momentum in the derivatives market to get built.
The regulators’ message, however, did not resonate with some banks. One official at a midsize bank, who did not want to be identified, said the bank was “holding out for term SOFR as long as we could.”
The bank started supporting term SOFR loans in September, two months after the Fed-convened group of market participants, known as the Alternative Reference Rates Committee, formally recommended a term SOFR rate.
“Although we haven’t booked many yet, it’s coming, and it’s going to come fast,” the midsize bank official said.
The delay in getting a term SOFR rate was largely due to a “chicken-or-egg” question, observers say. The SOFR derivatives market, where banks can turn to protect themselves against interest rate risks on any loans, was not robust enough earlier this year due to a dearth of SOFR loans. But banks were hesitant to make SOFR loans without a deep derivatives market to hedge risks.
But growing momentum in the SOFR derivatives market quickly shifted the situation and led the Alternative Reference Rate Committee to formally recommend a term SOFR rate. In a July 29 statement, the group said that market participants“ now have all the tools they need as we enter the transition’s homestretch.”
Banks are working hard to meet the upcoming deadlines, but adopting new rates requires a massive operational effort in preparing staff, systems and clients, said Meredith Coffey, executive vice president at the Loan Syndications and Trading Association. Coffey is co-chair of the Fed-convened committee’s working group on business loans.
“Adopting a new rate is like turning a battleship,” she said.
Staff Writer, American Banker