Credit Unions Should Embrace Libor Alternatives

The NCUA sent a letter to credit unions in January informing them they will be assessed for their preparation and exposure related to the Libor benchmark, which is set to expire in 2021.

There is little doubt this is causing agita for long-term credit union managers who have issued Libor-benchmarked loans to their members since the 1970s.

To them I say, it’s high time for Libor to go. It was an accident of financial history, based on a poll of banks with a very small cash market to price hundreds of trillions of dollars. Its demise presents opportunities for change and innovation that will benefit financial market participants.

In fact, we have multiple rates emerging right now to better serve specific segments of the market. The replacements are based on actual trades and are better suited to different segments of the marketplace.

For large financial institutions, there is the Federal Reserve’s SOFR (the Secured Overnight Financing Rate), which is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. The ICE Benchmark Administration, which took over the administration of Libor at the request of the United Kingdom government in 2014, has introduced another benchmark for large institutions that revamps Libor to mitigate credit risk.

Some mid-sized and regional banks, and credit unions, have started to find a solution. Credit unions have issued loans tied to AMERIBOR, a benchmark developed to meet the specific lending needs of regional banks and credit unions from the American Financial Exchange.

What else can credit unions do to prepare for the transition? To mitigate the risks of transition, institutions must understand their current risk profiles. How much is tied to Libor, and how much expires before and beyond 2021? What alternatives can be considered? From an asset-liability point of view, what can be done to prevent imbalances? The NCUA and other regulators will be watching for more disclosure and preparedness on these issues.

There are also educational issues – the use of new benchmarks will require educating loan officers, staff and customers. Many people don’t know that their mortgage and credit cards are tied to Libor.

Along with recordkeeping, education and transitioning to a new rate or rates, a bank needs to select the right rate. Does it accurately represent the cost of borrowing for an institution? If the chosen rate creates asset-liability mismatches, it obviously increases operational and financial risks for the bank. Boards and risk (ALCO) committees must be prepared to address these issues.

Support for change and choice is coming from regulators. The Federal Financial Institutions Examination Council is raising awareness and helping to educate financial institutions and examiners about planning and transitioning from Libor as a reference rate.

The transition to new benchmarks, and the creation of new markets that comes with it, will require building institutional infrastructure. That means that financial institutions and regulators need to be joined by accountants, lawyers and academics who can help provide the research and training required to help a new generation of professionals understand the changes and new options.

We have every reason to believe that the U.S. financial sector, the most developed, flexible and innovative in the world, will maintain an orderly and smooth transition to new interest rate benchmarks. Industry groups are organizing to educate stakeholders. There are contracts currently being traded on organized exchanges, which will provide greater transparency and price discovery. That will speed up adoption.

When it comes to alternative rates, choice is critical. It enables participants to pick the appropriate rate for their circumstances and helps lower systemic risk. In times of crisis, it is better to have a choice of rates rather than a single benchmark. A rate like SOFR caters to bigger players, while AMERIBOR, an unsecured rate derived from transactions on the AFX, is better suited for mid-sized and regional banks and credit unions. Financial institutions that embrace the transition will have a competitive edge in their community.

I urge credit unions to take the long view and embrace Libor alternatives. I started working on interest rate futures in 1969, and we launched the first futures six years later. It took a decade, and the Volcker tightening in late 1979, for them to take off. Likewise, in this scenario, there’s time for all credit unions and everyone involved to prepare and benefit from better choices ahead.

Richard Sandor is the Aaron Director Lecturer in Law and Economics at the University of Chicago Law School, as well as chair and CEO of the American Financial Exchange, an electronic exchange for direct interbank/financial institution lending and borrowing, in Chicago.