The Advantage of LIBOR for Community Banks

Libor As A Loan Index

Most community banks do not use LIBOR (London Interbank Offered Rate) to set loan or deposit rates, yet LIBOR is probably the most important index for community banks. In fact, while Prime and some form of Treasury indices are much more prevalent as a loan index for community banks, LIBOR is far more important for community banks in setting loan yields and determining deposit rates. Community bank CFOs and lenders must understand how LIBOR is determined and its yield at various maturities.

Background on LIBOR

LIBOR started being used by banks in the 1980s to allow banks to use a common reference rate.  This rate was intended to reflect the banks’ cost of funds. Rather than rely on each individual bank’s Prime rate, banks would have a common and transparent index. Today, it is estimated that there are approximately $350T of LIBOR based contracts (from institutional loans and derivatives, to deposits and small commercial loans).

While more and more community banks are starting to use LIBOR as the reference rate for loans, the vast majority of banks in the country rely on Prime and constant maturity Treasuries for interest rate indices.  Originally, LIBOR was administered by the British Bankers Association (BBA).  The BBA did not vigilantly supervise LIBOR setting and some bank traders started manipulating LIBOR in favor of financial gains. Traders colluded with each other to create extensive and intentional manipulation. While the manipulation would only move LIBOR by less than one basis point, nonetheless, multiplied by $350T in contracts outstanding, the impact was substantial.

The BBA LIBOR rate was set using a hypothetical rate set by submitting banks who determined how much they would pay for interbank funding if they were to fund in the interbank market. When the LIBOR scandal was investigated in 2012, recommendations were made on control and oversight for LIBOR, and to change from hypothetical LIBOR levels to actual transaction levels. 

One interesting anomaly under the BBA LIBOR was that participant bank’s submission for LIBOR was transparent to the public.  While appearing to be a positive, this transparency actually caused more manipulation. Weaker banks did not want to signal to the market that they had higher borrowing rates. These banks would understate their cost of borrower and, therefore, not all of the manipulation of LIBOR was motivated by direct profits.   

In February 2014, ICE (Intercontinental Exchange) took over the administration of LIBOR with a focus to eliminate the manipulation of the index. ICE has established a protocol for assessing and the submission of LIBOR based on real transactions in the market. ICE administration of the setting process is intended to regulate LIBOR and provide confidence in the LIBOR process.

Currently, LIBOR is set by ICE for five currencies and 7 maturities. LIBOR is set based on a trimmed average of actual transactions seen in the market. A trimmed average is the mean of the LIBORs submitted after eliminating the highest and lowest quartiles submitted for that day.  Instead of taking hypothetical LIBOR levels as was done under the BBA administration, currently banks that contribute to the LIBOR setting mechanism for ICE are asked the following question:  “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11am London time?”  LIBOR is now determined based on actual levels that contributing banks are transacting in the market. 

Why LIBOR Matters to Community Banks

The reason that LIBOR is important is not because of its prevalence within the community bank market (although more and more banks are starting to use LIBOR for indexing their assets and liabilities) but because the largest banks in the country set their loan rates (for variable and fixed rates) and their deposit rates based on LIBOR. Therefore, community bank’s cost of funding and adjusted loan yields are closely correlated to LIBOR.

 

Gross Loans And Leases

 

The graph above shows the concentration of loans for all banks in the country. It shows that the top 200 largest banks control the 82% of all loans in the banking system with the largest 10 banks controlling 43%.  

Total Deposits

This graph shows the concentration of deposits for all banks in the country. It shows that the top 200 banks control the 84% of all deposits in the banking system with the largest 10 banks controlling 48%. 

The top 200 largest banks in the country do use LIBOR to set loan and deposit rates. All banks in the country are de facto following LIBOR because the remaining 6,000 banks are competing for loans and deposits with these largest 200 banks. This is why community banks’ cost of funding is approximately 95% correlated to LIBOR and why community bank loan yields are no more than 25bps above those set by larger banks (after taking into account risk, size and relationship adjustments).

Conclusion

In order to make informed and effective decisions, community bank CFOs must understand current levels of LIBOR for various maturities (from overnight out to 15 years based on hedge rates). This term structure of interest rates based on LIBOR is the most important determinant of banks cost of funding today, and expected cost of funding in the future. Lenders must understand how loans are priced in the market based on LIBOR rates over various loan terms and amortization periods and starting dates.  While community banks may not use LIBOR directly, the index has tremendous importance in our business on both sides of the balance sheet.