About the authors: J. Christopher Giancarlo served as chairman of the U.S. Commodity Futures Trading Commission. He was previously an independent director of the American Financial Exchange, the sponsor of the Ameribor credit sensitive benchmark interest rate. Bruce Tuckman is a clinical professor of finance at the Stern School of Business at New York University. He previously served as chief economist of the CFTC.
Today marks the end of the London interbank offered rate. Libor, as it’s better known, has been the world’s dominant interest rate benchmark over the last 40 years. Libor’s demise happens to coincide with a challenging environment for U.S. regional and smaller banks and is an opportunity to reflect on what should come next. We believe that regulators should not insist on replacing the one-size-fits-all Libor regime with another one-size-fits-all benchmark.
Benchmarks play a vital role in the U.S. financial system. The S&P 500 index, for example, enables countless investors, asset managers, corporate officers, and commentators to assess general market conditions quickly and easily. Yet, that index is by no means the only widely used benchmark of U.S. equity markets. Similarly, benchmarks of short-term interest rates enable a multitude of short-term lenders and borrowers to gauge conditions of money markets.
Until the 1980s, the dominant short-term rate benchmark in the U.S. was the Treasury bill or “T-bill” rate. Its benchmark status eroded, however, for two reasons. First, T-bill rates are not “credit-sensitive,” that is, they do not reflect the borrowing costs of banks and everyday businesses. This defect is particularly problematic in times of financial stress, when rates on corporate commercial paper increase while T-bill rates decrease with “flight-to-quality” purchases of government obligations. Second, T-bill rates fluctuate with idiosyncratic changes in the supply and demand for T-bills, which is a nuisance for many benchmark users.
For these reasons, over the course of the 1980s, U.S. banks linked rates on corporate loans to a credit-sensitive rate, Libor, designed to reflect the rate on interbank loans. Libor eventually came to be widely used for floating-rate corporate bonds, adjustable-rate mortgages, other forms of consumer credit, and the rapidly growing derivatives markets.
The Libor regime began its decline during the financial crisis of 2007-09. First, expansive monetary policy around the world meant that banks hardly needed to borrow from one another. That, in turn, meant that Libor was being set more by subjective opinion than by observable market transactions. Second, investigative journalism revealed that banks understated their borrowing costs during the financial crisis and traders were manipulating Libor for profit. The resulting settlements and fines of more than $11 billion made banks reluctant to participate in setting Libor.
In 2017, global regulators decided to end Libor after a period of transition. Major challenges in moving away from Libor were the creation of new benchmarks and their insertion into the massive number of existing, Libor-based contracts. In the United States, regulators nominated the secured overnight financing rate, or SOFR. It reflects the cost of overnight borrowing secured by U.S. government obligations. The U.S. financial community, with the support of Congress, successfully and uneventfully migrated nearly all derivative contracts and most loan contracts away from Libor. Throughout this transition, however, regulators discouraged the development and adoption of credit-sensitive rate benchmarks by a lack of clear regulatory standards for non-SOFR benchmarks that amplified regulatory and commercial uncertainties.
With the transition from Libor complete, U.S. regulators should now support the use of other benchmarks in addition to SOFR. There is no reason to believe that markets are best served by one and only one benchmark. There is undoubtedly demand for both a benchmark based on safe, overnight loans, like SOFR, and credit-sensitive benchmarks as well. In fact, regulators in Europe have successfully overseen a two-benchmark approach. Furthermore, in light of Libor’s history, a one-benchmark regime can leave markets dangerously exposed to shifts in financial conditions.
Another reason to foster additional benchmarks is that SOFR is by no means perfect. One, SOFR is not credit-sensitive. Echoing the 1980s transition from T-bills to Libor, regional and community banks in the U.S. have been vocal about needing to manage risk by indexing loan rates to credit-sensitive rates, which better reflect the true cost of lending to small and mid-sized businesses. Also, recent academic research predicts that, without a credit-sensitive benchmark, banks will likely reduce their provision of credit lines, a grave eventuality when the U.S. economy may be headed towards recession. Two, SOFR fluctuates with the idiosyncrasies of conditions in government-bond markets, again echoing the 1980s transition away from T-bills. Three, SOFR is an overnight rate, while many borrowers prefer benchmark rates of one month, three months, or other terms. While regulators did eventually permit term versions of SOFR, they restricted the conditions of their use.
We believe, therefore, that regulators—in a manner consistent with safety and soundness—should honor the clear congressional intent of the Libor Act of 2022: Banks “may use any benchmark, including a benchmark that is not SOFR, that the bank determines to be appropriate” to the needs of its customers, its funding model, and its managerial capabilities.
Variety and choice are best for market performance and durability. An economy as broad and multifaceted as that of the U.S. deserves variety and choice in interest-rate benchmarks.
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