Lenders can use any reference rate they wish to replace LIBOR as long as they provide a “robust fallback rate” in case the original is discontinued, U.S. regulators said on Friday, in a win for smaller banks that had pushed back against a mandated replacement.
The London Interbank Offered Rate, which is an interest rate benchmark that’s used in hundreds of trillions of dollars worth of contracts in markets worldwide, is set to be eliminated by the end of 2021. Global authorities agreed to phase out the benchmark after it was tarnished by widespread manipulation scandals around the time of the 2008 financial crisis.
The U.S. Federal Reserve, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency have argued that the best LIBOR replacement is the secured overnight financing rate, or SOFR, which is secured with assets like U.S. Treasuries.
SOFR is also backed by larger lenders, and Freddie Mac issued its first credit risk transfer offering tied to the benchmark in October.
Small and mid-sized U.S. banks have pushed back against SOFR as a LIBOR replacement. American Banker reported in August that a group of 10 mid-sized banks told regulators that smaller banks “do not have large holdings of government securities and therefore can only borrow on an unsecured basis. That presents an immediate asset-liability imbalance and potentially creates distortions in times of financial stress.”
The three federal agencies listened, acknowledging Friday that different rates can be appropriate for different-sized lenders.
“The agencies recognize that banks’ funding models differ and that in structuring their lending activities it is appropriate for banks to select suitable replacement rates for LIBOR that are most appropriate given their specific circumstances,” the Fed, FDIC and OCC wrote.
“A bank may use any reference rate for its loans that the bank determines to be appropriate for its funding model and customer needs," the regulators said. "However, the bank should include fallback language in its lending contracts that provides for use of a robust fallback rate if the initial reference rate is discontinued.”
The regulators urged U.S. banks to select alternative rates and transition loans away from LIBOR “right away.”
“All institutions should have risk management processes in place to identify and mitigate their LIBOR transition risks that are commensurate with the size and complexity of their exposures,” the Fed, FDIC and OCC added.
Credit ratings agency Fitch expressed similar concerns to regulators in September, warning that banks were taking too long to transition away from LIBOR and adding that more loan issuers needed to incorporate fallback language.
As an alternative to both LIBOR and SOFR, many smaller lenders prefer Ameribor, which is based on transactions in the overnight loan market on the American Financial Exchange.