The moment of truth is finally here: the London Interbank Offered Rate (LIBOR) will be permanently shut down on June 30. LIBOR was once a crucial benchmark for the overnight lending market, but ultimately, the fact that it was not an observable rate — it was based on estimated borrowing rates rather than real transactions — left too much room for conflict of interest, leading to rate rigging scandals. As we embark on this new era, banks and financial institutions are now in a better position to gain a true understanding of their lending and borrowing costs.
To date, much of that improved understanding has come via the Secured Overnight Financing Rate (SOFR), which is based on observable transactions and less prone to manipulation. But SOFR does not account for key segments of the overnight lending market, which means that relying solely on SOFR could land many banks right where they started: struggling to get a clear sense of the price of doing business.
Every bank is different: Each one occupies its own market niche, with its own strategy in response to diverse sets of client needs. If the industry fails to account for this, the LIBOR sunset could easily turn into a case of throwing the baby out with the bathwater. To operate optimally, the market needs more than a single source of overnight lending intelligence — it needs choice.
Why? For one thing, SOFR doesn't capture the entire overnight market. As a secured rate, SOFR only reflects loans for which a significant amount of collateral has been posted, often in the form of U.S. Treasuries. This reduces the risk of rate rigging, but it comes with its own shortcomings. Most banks are not active in the repo market and do not have large positions in government securities — they can borrow only on an unsecured basis and therefore need a rate that better reflects this segment of the market. That means that the industry's use of SOFR — which is used to determine the interest rates and borrowing costs for
On the flipside, rates that are both observable and credit-sensitive provide a true reflection of overnight unsecured borrowing costs. Those can serve as the basis for additional rates that could range anywhere from one month to 30 months and beyond, with the ultimate goal to create views of credit-sensitive term structures that are observable and irrefutable.
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The importance of having visibility into unsecured lending and borrowing can't be overstated. During times of market stress, credit risk tends to rise, increasing banks' cost of funds — but secured rates are more influenced by broader economic factors and thus often decrease in adverse conditions. It's easy to see how a bank relying on SOFR could face increased borrowing costs while its SOFR-derived lending rates hold steady, inviting the potential for significant monetary loss.
This is exactly the kind of disconnect the International Organization of Securities Commissions (IOSCO) was referring to in its
All lending institutions, no matter where they sit, should be aware that while SOFR plays an important role, there may be other benchmarks that better meet their loan funding needs, fully addressing asset liability management imperatives. We believe competition breeds better, more precise offerings for the target market. Without that choice, a substantial portion of the market is forced to make critical business decisions using information that does not reflect their situation. They're not exactly flying blind, but conditions are cloudy and their radar screens are cracked.
This case for choice is being made at some of the highest levels of government. In a
No matter what it looks like, the bottom line is this: Banks and financial institutions have a choice in terms of interest rate benchmarks, and they should be aware of their various options and their potential use cases. With the end of LIBOR, there's no time like the present to ensure they are getting a real reflection of their lending and borrowing costs.
