Fed Funds and Libor are Changing and This is What Banks Need to Know

Libor+ Rate Index Changes

If you were a financial institution on the frontier during the late 1700’s you had an exchange rate for beaver pelts. Sometimes you didn’t trade any beaver pelts, or some problem customer brought in some deer skins to trade for cash and you had to either make up a beaver pelt rate or do some esoteric conversion in order to have an accurate index rate to base some of your deposit and lending activities on. Well, the beaver pelt problem isn’t all that different than our modern rate structure with LIBOR, Fed Funds and Prime, which is why it is changing.  

 

This is why last week, the Financial Stability Board (“FSB”) published a report that outlines a proposal for the reform of several major interest rate benchmarks.  It is about time, as our rates have never been all that accurate as evidenced by how Fed Funds performed during the recent financial crisis (or even over the end of the year), plus the fallout from the recent LIBOR scandal where several large banks were found to be manipulating the index.

 

While these reforms will impact a number of international rates, in the US they will affect the composition and calculation of LIBOR and Fed Funds. In short, the reforms look to increase the quality of the reference rate by adding actual transaction data to the current use of survey data.   

 

In 2015, FSB will test a “LIBOR+” rate that will serve as a benchmark for all credit products. Currently, LIBOR is composed of survey data gathered by the British Bankers Association from the world’s largest banks. LIBOR+ will be composed of actual LIBOR transactions (not a problem out to 3 months in term) and will be augmented by other instruments out longer in order to come up with a more accurate, composite term structure of rates out to 1-year. Like LIBOR, LIBOR+ will reflect about an “A1” / “A+” rated bank credit which makes it a suitable base rate for use in credit products.

 

For community banks, this means a couple things. Looking at performance over the past two years, LIBOR+ has to be slightly (0.5bp) lower in the short end (the 1-week area) and slightly higher (by 2.6bp) in the 3-month area. This rate will more accurately reflect funding costs (about an 85%+ correlation) if you apply a three to six month lag (depending on your bank). It is unclear if this relationship will hold by the time it is implemented in 2016, but our guess is the LIBOR+ will be higher due to structural reasons.  In addition, it will be more volatile. While all this sounds more risky, it is actually less so as it will more accurately reflect reality, which is step one to managing risk.

 

Given the timing, we predict that the regulatory focus of this more accurate rate index, paired with rising rates, will cause many community banks to abandon Prime and move to LIBOR+ as a loan index. Prime is an administrative rate and not a market rate, thus creating problems when managing risk. When rates rise, LIBOR+ will track market conditions, while Prime may lag for a year or more. 

 

In similar vein, while Fed Funds is a rate composed from actual transactions, it is largely US derived and thus does not present an accurate global benchmark. In addition, the rate does have a credit component to it, which skews accuracy, particularly during times of crisis. The alternative is that the FSB will likely move to an overnight general collateral repo rate that will reflect greater liquidity, and thus more accuracy. A move to a repo rate as an overnight benchmark will limit the huge spikes that we see in rates near quarter and year end that are a result of some large banks just being out of the market.

 

The net result of these changes will be changes in bank’s asset liability indices and benchmarks. Community banks will have to do some basic education to their boards and customers and get them used to working with an overnight repo rate instead of Fed Funds and using LIBOR+ instead of Prime. In addition, and almost equally important is the asset-liability aspect of now tracking deposits more accurately against LIBOR. This will allow better information and more accurate data for a wide variety of endeavors from rate setting, to duration/convexity computations and profitability calculations.

 

 We have come a long way from pricing deposits off beaver pelts, and moving to a LIBOR+ and repo methodology is a step in the right direction. You will likely hear much more about this over the course of 2015 and we expect implementation to begin in mid-2016.  It is a change that is starting to happen already, so banks should be aware.