By Daniel Kruger and Allison Prang 

Regional banks are struggling to move away from the troubled London interbank offered rate, saying alternatives to the key benchmark for variable-rate debt could hurt their ability to make new loans.

Those banks, including PNC Financial Services Group, Regions Financial Corp. and U.S. Bancorp, say they are concerned the new secured overnight financing rate, or SOFR, could notch outsize drops at times of economic stress. That could force banks to lend at low rates at times when their own borrowing costs are rising.

Preparing for the shift is critical because regulators in the U.K. overseeing Libor have said they won't ask banks to continue participating in the rate after 2021. Libor was discredited about a decade ago after a manipulation scandal led to billions of dollars in fines for banks and prison sentences for traders.

Now regulators and bankers are seeking a new rate to underpin trillions of dollars of financial contracts for everything from home mortgages to company credit lines. Banks, companies and investors all want a rate that reflects the risks from short-term lending, is supported by a liquid market and behaves in a predictable manner. Properly setting lending rates can determine whether loans are affordable for borrowers and profitable for lenders.

In the U.S., the transition to SOFR is being guided by a committee of Wall Street banks and investment firms convened by the Federal Reserve. The shift to SOFR is particularly thorny for banks, which make money by acquiring capital at low cost and lending it at higher rates. That is because SOFR is derived from super-safe U.S. government borrowing rates, which are essentially guaranteed to be lower than the rates at which banks can borrow.

Additionally, some bankers expect rates on variable-rate loans linked to SOFR to decline at times of economic stress, right when it typically becomes more expensive for banks to borrow. In a growing economy, Libor tends to be modestly higher than SOFR. Banks are worried that the difference will widen during a slowdown, as investors will rush into the relative safety of government debt, dragging down yields, while avoiding riskier corporate bonds, pushing those yields higher.

The committee concluded that "there was no way to bridge the gap" between Libor's sensitivity to credit risk and the reliability and depth of the repo market that underpins SOFR, said David Wagner, a senior adviser at Houlihan Lokey and a former participant in the group. That is a problem that could affect the ability or willingness of smaller banks to use SOFR, Mr. Wagner said.

The unexpected spike in repo rates in mid-September raised widespread concern about the use of those rates, which can be volatile, in the determining how SOFR is calculated.

A group of 10 regional banks in October sent a letter to the Fed, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency, arguing that the absence of a credit-sensitive reference rate could undermine the willingness of lenders to provide credit in periods of economic uncertainty.

"Obviously, we're studying it, but there are other indices that you can use," First Republic Chief Financial Officer Mike Roffler said on the company's earnings call in October. First Republic began using the Treasury one-year constant maturity rate in recent months. It "behaves in a much more logical fashion," which is good for consumers, Mr. Roffler said.

It is possible for borrowers accustomed to Libor to use derivatives and other financial contracts to arrive at a rate that resembles the expiring benchmark, analysts said. It could be difficult, however, for regional banks to sell such strategies to their customers who are less used to the additional trades that would be part of such a strategy, they said.

Some regional banks are going to explore alternatives to SOFR, including the prime rate, which is the base rate banks charge creditworthy commercial customers, or the effective federal-funds rate, which reflects the rate large banks charge each other for loans.

The reluctance of these banks to use SOFR could also help rival benchmark rates gain traction. The American Financial Exchange, which allows smaller banks to lend to each other through mutual lines of credit, also publishes the Ameribor reference rate. It plans to ask the committee to include both SOFR and Ameribor when it recommends alterations to contractual language aimed at minimizing potential problems from the transition, according to Chief Executive Officer Richard Sandor.

While borrowers can adopt their own contractual language, participants on the Fed's committee are unlikely to change their recommended legal templates. Some committee members think banks will eventually have a choice of different reference rates after Libor expires, but they said the complexity of the transition doesn't leave enough time and resources to concurrent preparations for multiple benchmarks.

"By no means are we discouraging anyone" from offering alternatives that could address banks' concerns about credit risk, said Tom Wipf, vice chairman of institutional securities at Morgan Stanley and chairman of the alternative-rates committee. "Unfortunately, the task is not that simple, and if it was we would've done it a long time ago."

To receive our Markets newsletter every morning in your inbox, go here.

Write to Daniel Kruger at Daniel.Kruger@wsj.com and Allison Prang at allison.prang@wsj.com

 

(END) Dow Jones Newswires

December 04, 2019 08:14 ET (13:14 GMT)

Copyright (c) 2019 Dow Jones & Company, Inc.
Regions Financial (NYSE:RF)
Historical Stock Chart
From Feb 2024 to Mar 2024 Click Here for more Regions Financial Charts.
Regions Financial (NYSE:RF)
Historical Stock Chart
From Mar 2023 to Mar 2024 Click Here for more Regions Financial Charts.