Five years ago, a small bank that almost no one had ever heard of launched an epic battle against three of the largest financial institutions in the world for their role in facilitating a crisis that began more than a thousand miles away. In 2012, Community Bank & Trust, of Sheboygan, WI, filed a class action suit against Bank of America Corp., Citigroup and JPMorgan Chase & Co. for their part in the manipulation of the London Interbank Offered Rate, or LIBOR—the benchmark rate for tens of thousands of financial contracts including commercial loans, home loans, student debt, mortgages and municipal debt. The lawsuit claimed that small financial institutions like Community Bank & Trust lost $300 million to $500 million a year due to LIBOR rigging, and that big banks were part of an ongoing criminal enterprise and guilty of violating the Racketeer Influenced and Corrupt Organizations (RICO) Act.
LIBOR is the average rate at which a group of large, global banks—including Bank of America, JPMorgan and Citi—estimate they’d be able to borrow funds from each other in five different currencies across seven time periods, submitted by a panel of lenders every morning. U.S. banks began their gradual transition to the metric in the 1990s because, unlike the Prime Rate that was widely used prior to that period, LIBOR changes daily and is—in theory—tagged to market conditions.
LIBOR has been called the “most important number in the world,” and even though most community banks rely on Prime and constant maturity treasuries for interest rate indices to set loan or deposit rates, LIBOR is still a critical index for community banks. In the case of smaller commercial lenders, even minor fluctuations in the LIBOR rate can have significant consequences. By manipulating the floating rate, large banks with greater borrowing power and cash reserves can artificially suppress the index, squeezing returns for smaller institutions.
“The defendant banks, sophisticated investors who understand that LIBOR is a key metric, knew that manipulating [the rate] downward would directly and proximately harm the small community banks in which the defendants compete for loan business by artificially depressing the interest rate paid to community banks on loans held by those banks,” the complaint asserted.
That litigation is still playing out in a federal appeals court in New York. Meanwhile, financial institutions around the world have shelled out more than $9 billion in fines and settlements since then to settle litigation related to the LIBOR scandal, and several bankers have faced criminal convictions. But LIBOR is now on its way out. On July 27, 2017, Andrew Bailey, chief executive of the U.K. Financial Conduct Authority, announced that LIBOR will officially be replaced as the key index for overnight loans. As a result, lenders will transition to alternative rates over the next four years.
This summer the Federal Reserve’s Alternative Reference Rates Committee (ARRC) identified a broad treasuries repo financing rate as its U.S. dollar-preferred LIBOR alternative. The new metric will be called the Secured Overnight Financing Rate (SOFR), and will include tri-party repo data from The Bank of New York Mellon Corp., and cleared bilateral and General Collateral Finance Repo data from The Depository Trust & Clearing Corp. (A repo transaction is the sale of a security or a portfolio of securities, combined with an agreement to repurchase the security or portfolio on a specified future date at a pre-arranged price).
While protocols for making the transition have not yet been finalized, it’s not too early to begin preparing. According to the Loan Syndications and Trading Association, while most credit agreements already include customary fallback language if there is a temporary disruption to LIBOR, it would be prudent for parties to review their existing credit agreements to understand those provisions and what, if any, amendment flexibility exists to address a discontinuation of LIBOR. And as new agreements are drafted, parties may want to consider the ability to amend the agreement with less than a 100 percent lender vote to avoid market disruption in the event that LIBOR is permanently discontinued.
To make informed decisions, it behooves all community banks, even those that do not directly use LIBOR, to consider how the replacement metrics may impact their own interest rates.
Commercial banking is a core business for most regional and community banks. It is a key driver of profitability as well as organizational growth, and frequently serves as the entry point to many of the bank’s other businesses, such as wealth management, treasury services and deposit gathering. The competition for talent and growth within commercial lending has never been higher, and as a result, commercial lenders continue to be among the mostly highly paid and highly incentivized individuals in the bank. It is of critical importance therefore to think carefully about maximizing your bank’s return on its lender compensation by thoroughly evaluating your incentive programs for this group. Do the plans motivate the right behaviors, properly consider risk elements and successfully align compensation with performance?