Regional banks sound alarm over new interest rate benchmark
WASHINGTON — Executives from 10 regional banks sent a letter to the federal banking regulators last month expressing concern that a new interest rate benchmark set to replace the London interbank offered rate will limit credit availability.
Libor, which has been found to have been subject to manipulation in recent years, will be phased out as early as 2021 and will be replaced with the secured overnight financing rate.
But SOFR on a standalone basis “is not well suited to be a benchmark for lending products,” top executives from BBVA USA, Capital One, Citizens Bank, Comerica, Fifth Third, M&T, MUFG, PNC, Regions and Zions wrote in a Sept. 23 letter obtained by Politico.
“During times of economic stress, SOFR (unlike LIBOR) will likely decrease disproportionately relative to other market rates as investors seek the safe haven of U.S. Treasury securities,” the executives said in the letter, addressed to Federal Reserve Vice Chair for Supervision Randal Quarles, Federal Deposit Insurance Corp. Chair Jelena McWilliams and Comptroller of the Currency Joseph Otting.
That could lead to a “mismatch” between bank assets and liabilities, the banks warned.
“The natural consequence of these forces will either be a reduction in the willingness of lenders to provide credit in a SOFR-only environment, particularly during periods of economic stress, and/or an increase in credit pricing through the cycle,” the letter said, noting that this could increase procyclicality.
Instead, the banks suggested creating a SOFR-based lending framework that would include a credit risk premium. This structure would be based on a “dynamic spread that reflects changes in banks’ cost of funds over forward-looking term periods.”
“With more closely aligned borrowing and lending rates, banks will be more willing and able to extend credit during both good times and bad,” the banks said. “Including credit sensitivity as part of the framework is the most straight forward approach to achieve this alignment, as it enjoys the benefits of using SOFR as a robust underlying rate and does not require complex hedging strategies which are ill-suited for smaller Main Street lenders and community banks with less complex balance sheets.”
The letter comes at a time when concern is mounting that financial institutions are ill-prepared for the transition away from Libor. In June, Quarles urged the private sector to transition to SOFR immediately, or abandon Libor altogether.
In their letter, the bank executives also asked the regulators to create a private market participant industry working group to explore supplementing SOFR with a credit-sensitive rate element in the lending markets.
“We believe inclusion of a credit risk premium is essential to addressing the concerns outlined above and will make the banking system and, in turn, the U.S. economy more resilient during times of economic stress and facilitate the transition of lending markets from LIBOR,” the letter said.