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November 12, 2019

Lenders Need to Prepare for Life After LIBOR

EXCERPT: With LIBOR slated to be replaced by SOFR in a couple of years, many banks are concerned about the effects that the transition may have on their bottom line. That said, there are steps that banks should take to prepare for the change, including reassessing their loan portfolios.

With LIBOR slated to be replaced by SOFR by 2021, many banks are concerned over the effects on their profits, particularly in a time of economic stress.

By 2021, the London Interbank Offered Rate (LIBOR) will be taken over by the Secured Overnight Financing Rate (SOFR), putting banks and lenders in a position to make some changes to avoid any interruption in the lending market.

LIBOR is a benchmark rate used across the globe for short-term rates, and it represents the average interest rate that banks borrow from other banks in the London market. On the other hand, SOFR is based on rates for overnight loans that are secured by Treasuries, which behave differently.

Within a couple of years, the LIBOR reference rate will cease to exist, placing banks in a potentially challenging position to transition to a new interest rate benchmark that could cause financial instability.

Concerns Over the Switch From LIBOR to SOFR

The 2021 deadline is fast approaching, and some are concerned that many banks are not moving fast enough or taking the required transition seriously enough to ward off any disruptions in the lending sphere. Some banks aren't too fond of the new SOFR, claiming that it could lead to pullbacks on credit among lenders because of potentially higher credit costs, particularly during a period of economic uncertainty.

Unlike with LIBOR, SOFR is feared to decrease much more than other market rates during times of economic stress and tighten the bottom line of banks and lenders, which is not the case with the current LIBOR. As investors turn to other safe places to park their capital, bank assets and liabilities could be negatively impacted.

Banks and lenders should take a proactive approach to the transition from LIBOR to SOFR by reassessing their loan portfolios.

Such a situation could prompt lenders to retreat from providing credit or lead to a boost in credit pricing through the economic cycle. Banks who fear SOFR's potential negative impact on lending are instead recommending that a SOFR-based lending framework be developed to incorporate a credit risk premium.

Some Claim SOFR's Issues Are Exaggerated

Others aren't nearly as concerned, saying that the fears over potential disruptions are overstated and will likely not come to fruition. Despite any fuss over the change and some growing pains, proponents of SOFR believe that the new benchmark will arrive without much impact on financial stability among banks and lenders.

With two years still left before the change is slated to take effect, the real risk of the switch to financial stability is tough to distinguish.

The Federal Reserve, which is promoting dialogue about the change, seems to understand the concerns over SOFR but isn't exactly putting the complaints at the forefront as it continues to deal with other issues. New alternatives to LIBOR might be even less ideal than SOFR for new lending products because of the lack of a credit-sensitive component.

Financial Institutions Should Reassess Their Loan Portfolios

While banks and lenders make the necessary changes to prepare for the transition, they should also be reassessing their loan portfolios to ward off risk, particularly as the changes approach and economic uncertainty remains an issue. To accomplish this, financial institutions are encouraged to work with a team that can help sell off risky assets and replace them with stronger ones, and Garnet is the perfect partner to do just that.

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