While most community banks do not use LIBOR extensively for their loans and deposits, many community banks have at least a handful of loans or other cash instruments that do reference LIBOR as the benchmark rate. This article outlines what community banks need to know at this stage of the LIBOR transition period.
Today marks a significant day in banking history as it is one of the few times that the interest rate market has seen the creation of a new index. No doubt you have heard about the theoretical phasing out of the Libor Index after 2021 and the transition to the Secured Overnight Funding Rate (“SOFR”). With approximately $200 trillion in volume, Libor is one of the largest financial indices in the world. In this article, we look at this newly published rate and discuss some ways that banks can best prepare for this potential transition.
In November 2014 the Federal Reserve convened the Alternative Reference Rates Committee (ARRC). ARRC has two goals: first, to identify alternative reference interest rates that are more firmly based on market transactions; and second, to identify an adoption plan to facilitate the transition from LIBOR.
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.
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.