Every community banker is familiar with the Prime rate, and most community banks do not have many loans or deposits tied to LIBOR. The question comes up – should you have more LIBOR loans? The answer is a clear yes and while LIBOR is slightly harder to explain to some borrowers, there are 6 good reasons to switch from Prime to LIBOR. First, LIBOR has more influence on community bank financial performance than Prime. Second, in some instances, LIBOR-based loans can reduce operational overhead for community banks. Third, community banks can reduce basis risk by using LIBOR instead of Prime. Fourth, in a rising rate environment LIBOR-based loans are more profitable than Prime-based loans. Fifth, where Prime is an administrative rate, LIBOR is a market rate, and thus a better reflection of risk. Sixth, because of the above. LIBOR-based loans are more marketable should you ever want to sell and thus more liquid.
To understand why LIBOR is so important, we must consider that the vast majority of community bank competitors predominately use LIBOR as their loan and deposit index.
LIBOR is by far the most widely-used benchmark for short-term interest rates in the world and in the United States. LIBOR is the average rate at which banks can borrow short-term rates from each other and is used as the index for the vast majority of loans and deposits world-wide. There are currently up to 18 contributing banks for five major currencies (US$, EUR, GBP, JPY, CHF), and for seven different maturities. A total of 35 rates are posted every business day (five currencies times seven maturities). The US dollar 1 and 3-months are the most common quoted rates in the world.
LIBOR is used as the benchmark reference rate for debt instruments, including government and corporate bonds, mortgages, student loans, and credit cards.
How LIBOR Can Help Community Banks
In a rising rate environment, LIBOR is a better index for lenders. Because LIBOR anticipates Fed Fund increases, LIBOR will rise before Prime does. For example, a LIBOR-based loan portfolio, with an identical nominal yield today will earn the lender four to eight basis points more per annum than the same loan portfolio priced to Prime (four to eight basis points is dependent on the LIBOR maturity used and how many times the Fed raises rates next year). In a very competitive lending environment, eight basis points is meaningful - $80k per $100 million loan portfolio.
We have equalized the two rates below in the graph and you can see where LIBOR is higher than Prime that the difference would accrue to your bottom line in a rising rate environment.
LIBOR is operationally easier for loan administration. LIBOR resets on a periodic basis (typically monthly or quarterly) and this allows easier billing, accrual and posting. Instead of waiting until the last accrual day in a Prime period, a bank using LIBOR can set up all entries in advance (accounting, payables and processing is simplified because LIBOR is set in advance and paid in arrears). LIBOR was designed to be operationally friendly.
While it may appear odd at first, LIBOR is a better proxy for community bank’s cost of funding than Prime. The numbers speak for themselves. Over the last 20 years, 1-month LIBOR and Prime show a 96.5% correlation. That correlation is very strong but it is not perfect. So which index is a closer match to the average community bank’s cost of funding? You would think that with lack of LIBOR based deposits that community banks’ cost of funding would have low correlation to LIBOR. But that is not the case. We looked at cost of funding for all banks in the country from 1990 to the present by various size buckets. We found that the smaller the bank the higher the correlation between COF and LIBOR.
For all banks in the country, the correlation between COF and LIBOR was 92.8%, but only 86.8% between COF and Prime. Smaller banks actually show a higher correlation between COF and LIBOR. The reason is that on average smaller banks have lower DDA balances and thus higher reliance on interest rate sensitive deposits. While no community bank prices deposits expressly to LIBOR, because larger banks do follow LIBOR and price their deposits off the LIBOR curve, when smaller banks compete for deposits, they implicitly are also pricing off LIBOR. Thus, the end result is that community bank’s cost structure is very largely driven off the LIBOR curve, and less so off the Prime curve.
Until the great financial crisis some of the discussion between LIBOR and Prime was theoretical because we rarely saw the two indices diverge very much. After all, LIBOR and Prime are 96.5% correlated. However, in the height of the recession, when Lehman Brothers collapsed, LIBOR spiked while Prime continued to move lower. The cost of funding for community banks rose with LIBOR rather than fell with Prime. That is an important basis risk for community banks to keep in mind.
Prime may or may not move in connection with the market, but LIBOR, on the other hand, is a market rate and changes to reflect both interest rate changes and systemic credit changes. Further, because of this close correlation, banks that are on top of their risk management game convert all indices in the bank back to the LIBOR / swaps curve. In this manner, banks can have a single reference point to understand the base rate for all loans, deposits and fees. This simplifies risk management as banks more easily compare how the spread movement of say their certificates of deposits compare to their loans based on FHLB advance rates or Treasuries.
Historically community banks have not favored pricing instruments to LIBOR. However, community banks must compete against the largest banks in the country and those banks do expressly price deposits to LIBOR. Community banks’ COF by default is highly correlated to LIBOR. Certain LIBOR-based loan portfolios can help community banks in raising yield, decreasing overhead, and decreasing certain basis risks. While most community banks will not embrace LIBOR-based loans overnight, by generating some LIBOR-based instruments most community banks can enhance their financial performance over the next few years.
Submitted by Chris Nichols on January 11, 2016