Mark Meloy:
Hello, I'm Mark Meloy, CEO of First Business Bank. I'd like to welcome you to another episode of the First Business Bank podcast. Today, we are discussing the upcoming elimination of LIBOR, as a base rate. And what does that mean for borrowers and banks? I'm joined by two colleagues today and I'm gonna have each of them introduce themselves, before we get started. Ed?
Ed Sloane:
Sure. Thanks Mark. Uh, Ed Sloane I'm the chief financial officer of First Business, financial services. And I've been with the company for approximately five years. Uh, about 35 years in banking in, in total.
Mark Meloy:
Thanks Ed. Bill?
Bill Uelmen:
All right thanks Mark. Uh, Bill Uelmen, I'm director of treasury at First Business Bank. Uh, have been with the bank for just under five years and been in banking for over 30 years.
Mark Meloy:
Good, good. Well, let's get started and I'll direct the first question to you. What's LIBOR, what exactly is the... The topic we're talking about today, what's LIBOR?
Ed Sloane:
Sure, (laughs) sure. Thanks. Um, LIBOR stands for London Inter-bank Offered Rate. Uh, it's a benchmark or a reference rate, or an index. You can use those terms synonymously here. And it's a, it's a rate that, uh, that banks use to, to lend to one another. It's, um, it's calculated and published on a daily basis through the Intercontinental Exchange. Um, and it's a very common index for a wide range of, of financial products.
Ed Sloane:
Uh, it's widely accepted, uh, uh, across the, not only the United States, but, world all over. Uh, it has a significant global market, you know, about 300, 350 trillion of outstanding business, uh, is tied to a LIBOR, and at different maturities. So it's not just an overnight rate. Uh, it's a combination of five different currencies, seven maturities, you know, 35 different LIBOR rates that, uh, that are, you know, calculated and published each day.
Ed Sloane:
So you can just imagine Mark, the massive undertaking that we're talking about here, to eliminate LIBOR, and move to an alternative, alternative index. So significant, significant market presence.
Mark Meloy:
Thanks. I know that uh, LIBOR has been around for awhile, and when I got in banking 35 years ago, it was really prime. And ultimately over the years, the LIBOR became an alternative base rate. It's been ext- so it's been around for extended period of time, um, as has been mentioned, but Bill what's, what's happening. Why is the change being made to transition away from LIBOR?
Bill Uelmen:
Well, I mean, LIBOR goes back, you know, almost 50 years, like you had mentioned. And LIBOR tarted to be used in the markets as it was more of a market driven rate. So, banks in the 70s started placing Euro-dollar deposits, and off of different currencies and things, and really sophisticated borrowers started using this for, you know, interest rate derivatives swaps, commercial loans, residential loans, you know, investment securities. So it really became really widely used.
Bill Uelmen:
Then in the 80s, you know, the really the regulators realized how much activity was really happening with, with LIBOR. And they started to put in the different term structures that Ed had mentioned. So the different terms, the different settlement dates, really put a lot of structure behind it. And it created a lot of standardization behind LIBOR and that structure.
Bill Uelmen:
And as you said, you know, really in, in the U.S., mostly prime was the primary driver, primary index [inaudible 00:06:50] being used. And it's really been really more in the last 15, 20 years where LIBOR has really taken over that index in financial markets.
Mark Meloy:
So, what products is, we're talking about it today, and you have many clients that are going to listening on, on this conversation, ultimately. Um, what, what types of products and instruments does it impact for, what would be more commonly used by our clients and prospects?
Bill Uelmen:
Sure. So, so banks really use LIBOR in many parts of the balance sheet, that they use it for their deposit pricing. You know, commercial and residential loan pricing like I mentioned earlier, corporate debt offerings. And then interest rate derivatives and things to protect against interest rate risk. So really a first business, we primarily use LIBOR for our floating rate loans, corporate loans on, on our balance sheet.
Bill Uelmen:
We do some, um, you know, derivatives, cashflow hedges and things to lock in our, our, you know, fixed funding. And we do uh, use interest rates swaps, for a lot of our loan clients who are really looking for a fixed rate alternative. So we can offer a floating rate loan, swap at the fixed, and then swap it back to floating rate, um, on the bank's balance sheet, which we prefer, and do that through a back-to-back swap program.
Bill Uelmen:
So, we, we use the LIBOR really fairly extensively and, you know, it's, uh, obviously that Ed had mentioned a very large market and, you know, again, our balance sheet as a significant exposure to, to LIBOR-
Mark Meloy:
Mm-hmm (affirmative). Hmm. So, how does this impact all banks and other lenders alike and businesses and consumers alike?
Ed Sloane:
Yeah. All the above Mark. Uh, yeah. It's, uh, as we've been saying here, you know, LIBOR is a very widely used E- index. So, it impacts a variety of products. I know Bill, you, you mentioned some, you know, not only in the commercial space, but also in the retail, uh, credit, you know, various credit lines, home equity lines, credit cards, student loans. Um, you know, have, uh, a have a, uh, have a tie into, to LIBOR.
Ed Sloane:
And then on the, on the deposit side, money market deposit accounts that are prevalent in the, in the, uh, the banking industry, and even CDs to take advantage of some of the, uh, uh, the maturity structure that's out there with, uh, with LIBOR. So, E- it's a, it's a very popular index. You know, uh, inciting some of the, the, um, the breadth of, of LIBOR, and 1.3 trillion in consumer loans, that have a rate tied to, to LIBOR.
Ed Sloane:
So, you know, it just gives you an idea of the, of the relative size of just in the consumer loan business, how, uh, how much LIBOR is used. So when you think about it, in terms of the financial institution side, uh, you know, smaller financial institutions tend to be a little more plain vanilla with, uh, with their lending products in particular. And those would tend to go more towards a prime rate, and a fixed rate type, uh, type loan.
Ed Sloane:
So you don't get into derivative structures, swaps and things like that, so much in a, in a smaller institutions, but, you know, take first business as an example, Mark. And, uh, you know, you see a, you know, a larger financial institution that have larger, more complex, uh, business and commercial type customers. You know, they, they're looking for different types of structures. And so, when you break that down in our balance sheet, you know, probably talking about 50% of, of our loan portfolio is fixed rate. And the other 50% is variable.
Ed Sloane:
And most of those variable rate loans are tied to uh, tied to LIBOR. We do have some that are, uh, that are prime based as, as well, but, uh, but a good many of them are, are, are LIBOR based. And then, um, and then those that are LIBOR, you know, we'll, uh, we'll, uh, there are a number of those that we'll have a, uh, a swap arrangement, or a derivative type arrangement around those.
Ed Sloane:
So, to Bill's comment earlier about swapping a variable rate for a fixed rate, on the client's side, and, uh, and then the bank takes, uh, takes the variable position. You know, from a client perspective, this improves, um, you know, where they are in terms of their interest rate risk, we're in a low interest rate environment that can lock in that, that fixed rate. And then also take advantage of some favorable pricing, uh, around that derivative. So, um, that's, that's been the most common use.
Mark Meloy:
Hmm. So, I was gonna go away, Bill I'll direct this question to you-
Bill Uelmen:
Mm-hmm (affirmative).
Mark Meloy:
... Um, sort of banks considering as a replacement index to LIBOR?
Bill Uelmen:
Sure. So, I guess a little history too, going back. Um, previously that the reason why we're going through this process is that, LIBOR turned out to be more of a rate that banks were setting for their deposit costs. And back into the, whatever on the Great Recession, and subsequent years after that. Um, it was found that many of the banks were manipulating the rate in their favor. So, doing transactions and trades and things that, um, that were linked to LIBOR.
Bill Uelmen:
So, what happened then is regulators created a committee to create an, a new index, to have a replacement index for LIBOR. And this committee is ARRC, A-R-R-C, which is Alternative Reference Rate Committee. And about three years ago, ARRC recommended that we switched to SOFR. S-O-F-R, which is the Security Overnight Funding Rate. This rate is the average of the treasury repurchase agreement transactions that are posted every day.
Bill Uelmen:
So the Federal Reserve in New York will, uh, come up with the average rate and post that on a daily basis. And, you know, this rate, I guess, is a new rate in the market. It's been published now since roughly 2018.
Bill Uelmen:
Okay. Um, so June of 2017, the ARRC committee recommended choosing SOFR as the overnight funding rate. Which is Secured Overnight Funding Rate. The Federal Reserve, New York calculates the average treasury repurchase agreement, uh, rate on a nightly basis, and post that as an average rate for SOFR. So, it's a considered more of a secured rate, and different than a prime rate or fed funds rate, then, which is more of a managed rate. The... Pause a second.
Bill Uelmen:
So with, with SOFR the derivative market is starting to develop. So that again, it's currently a fairly new market and they're, they're starting to add transactions on a daily basis. First Business Bank, we're likely to follow what larger banks do, in choosing SOFR as our replacement index. Right now, what does it look like that LIBOR index that we will choose. But again, the larger market makers will determine that. Um, and LIBOR will go away.
Bill Uelmen:
So one of the things that we do have to do with this exercise is real- realize that the LIBOR rate will no longer be posted after December 31st, 2021. And it's possible that the rate would be sunsetted prior to that date. So we need to make sure that we have things in place, to replace LIBOR with the new replacement index.
Ed Sloane:
Yeah. Let me add to that for a second Bill, if I could. Uh, yeah. So as, as Bill indicated, it's not clear at this point, whether or not SOFR is going to be the, the replacement index. Uh, market participants, uh, large banks will make that determination likely as we move towards mid 2021. But until then, very important that banks, and this is what you were keying in on Bill, that banks really, to gear up for, uh, for that tran- transition. How are they, how are they doing that? Well, uh, we're looking at our new loan contracts.
Ed Sloane:
And so any new loans that are, that are being added, we make sure that the contract has, uh, a language in it that addresses an alternative rate index. Not a specific index at this point, but at least that there is an alternative rate index, that's a, that's likely to occur and be there as a replacement for, for, uh, uh, for LIBOR. We call that adding fallback language into, into the document.
Ed Sloane:
And the other, the other thing that we need to be cognizant of are those existing contracts. The ones, you know, with our, with our current clients that, um, you know, doesn't happen through a new contract, but we need to actually physically go in there, and talk to our clients, um, and, and explain to them what we need to do and to modify that, that contract, um, to also include that fallback, or alternative index language.
Ed Sloane:
So, that's a big undertaking when you think about, uh, the size of the portfolio that I was talking about here, 50% variable rate. We have a lot of library based, uh, uh, loans that are out there and new ones that are being added. And, uh, so we need to be on top of this from a, um, you know, from a contract perspective to make sure that we have at least, uh, allowed ourselves the opportunity to, to make that rate change. So that when the new rate is changed, then it, then we can really expedite the process.
Mark Meloy:
So, um, to be, to be clear, that clear, clear on that would be basically an addendum. We would need a borrower if, if they don't have the fallback language in it. Now, in other words, the seamless transition to an alternative base rate, it would basically be a, a one or a two-page type of in the denim that we would attach to, um, the knower make part of the note by reference?
Ed Sloane:
Yes, precisely. I think banks originally started out by saying, "Okay, you know, we need to go into the original contract to make a change," but now we are working with, uh, our legal team to, um, to put together more of a standardized addendum. So, we don't have to go into the original contract and, and in essence, create a new contract or agreement, but instead we can just have, like, you had suggested Mark a one, or a two page addendum to that. That'll be uh, a much more efficient process for not only us, but for the client.
Mark Meloy:
Okay, good. Bill you touched on this a little bit, but what are the pros and cons to a replacement rate for banks and really for the client borrower?
Bill Uelmen:
Sure. Well, the pros really is that, you know, SOFR is a market driven rate. So, going back to LIBOR where banks are setting a rate on a daily basis, they're really, there's no transaction that's related to that pricing is just the bank placing their deposits for the day. Where SOFR again, is that average of all the treasury purchase agreement transactions for the day. And there's thousands of transactions, maybe tens of thousands of transactions every day.
Bill Uelmen:
So it's very, very difficult to manipulate compared to what LIBOR was. So it's really, that's one of the key positives. The negatives of course, that W- you know, we need to learn a new index, right. We just started getting comfortable, I guess, as we said that the latter half of the, uh, you know, last few years, or last 15 years, and now we have to learn the SOFR index.
Bill Uelmen:
So I think there'll be a little, you know, learning process, learning curve, essentially for the market. There's also been some volatility between SOFR and LIBOR. So on times of liquidity needs, we've seen the two indexes differ a little bit, uh, over the last two and a half years. Uh, the difference you'll, I guess, is averaged out over time.
Bill Uelmen:
So again, it's been small, but there has been a, a variable between the two. And, uh, right now, still for, as a relatively new market. So there isn't a term structure established like they do for LIBOR, and W- but we do feel that is being developed, and it will be in place prior to the end of the next year. Uh, the market for SOFR is probably about half what LIBOR is right now. Um, but we do anticipate that obviously to increase over time.
Bill Uelmen:
And then lastly, um, really more operational for our first business bank. Some of the loan systems need to be updated to be able to come up, and calculate the SOFR rate, which is more of a compounded look back rate versus LIBOR being a forward looking rate. So a few operational issues on our end that we have to, to go through as well.
Mark Meloy:
Hmm. Okay. Um, yes, tell, tell me if I'm right on this, but as I think about sort of the market evolution to LIBOR being, becoming over the last 20, 25 years, as you mentioned, Bill sort of more commonly used by middle market type borrowers was the compelling part of it was, it was a market driven rate as opposed to prime, which is, is really a market managed rate, right?
Bill Uelmen:
Mm-hmm (affirmative).
Mark Meloy:
I mean, you'd said it's kind of set at the Fed level and in, in with some arbitrary decision-making behind it. Um, but it's, it's kind of evolved away from that as you described in terms of what happened as through regulate, regulators oversight. Till now, SOFR as an example is really in its purest sense is really a market-driven rate. So it's kind of getting back to what the original intent purpose was, with the then growing popularity of LIBOR boosts its prime, as an example, is that a, is that a fair statement?
Bill Uelmen:
Yeah. Yeah, it definitely is-
Mark Meloy:
Mm-hmm (affirmative).
Bill Uelmen:
... And as you mentioned, you know LIBOR, does have a bit of a credit component built into it because it's the inter-bank lending-
Mark Meloy:
Mm-hmm (affirmative).
Bill Uelmen:
... rate.
Mark Meloy:
Mm-hmm (affirmative).
Bill Uelmen:
So banks have a credit they're very strong credits, but we know banks can fail. So they build a credit component into that pricing. SOFR is a secured rate because the overnight advances in borrowings are secured by government, U.S. government securities. So they're a hundred percent guaranteed. So there's a difference between the two because of the credit difference.
Mark Meloy:
Got it, got it. Um, Ed does, does this change, um, away from LIBOR I mean, uh, extra risk or different risks to businesses, or borrowers?
Ed Sloane:
No, not, not, not really. I think with the, uh, initial rate, um, under the new index-
Mark Meloy:
Mm-hmm (affirmative).
Ed Sloane:
... you know, we'll be, we'll be the same rate as the same current rate as what's, uh, what's being provided under, under LIBOR. Um, well, you know, I, while the rates, you know, will remain the same, it's really the underlying index as Bill was describing that changes. You know, so for us a little bit different rate than, than LIBOR. So that spread between the index and the rate being offered will, uh, is where the variation occurs.
Ed Sloane:
Uh, the thing that remains to be seen as Bill pointed out is, um, some variability, if we do go to SOFR some variability between, uh, the way SOFR reacts to changes in, uh, in, in interest rates, versus LIBOR. And that's where you could see, you could see some risk, uh, you know, in particular, in, uh, in the short term, but over a period of time.
Ed Sloane:
And I think as that, that market continues to build for SOFR, you know, you'll see, you'll see those two rate rates act pretty similar. Would you agree with that Bill?
Bill Uelmen:
Yeah, I would. And I guess I can give a little bit of history right now. Um, the last two and a half years, uh, LIBOR ans SOFR had deferred by about 11 and a half basis points when looking at one month LIBOR, which is our primary index-
Mark Meloy:
Mm-hmm (affirmative).
Bill Uelmen:
... that we use on our balance sheet. So LIBOR has been 11 and a half basis points higher than some of her. So we would need to adjust the index or the credit spread to make sure again, it's apples to apples and that the fixed rate calculation, or the floating rate calculation is really the same.
Bill Uelmen:
So, it really doesn't the change of this index doesn't benefit first business bank. It doesn't hurt the clients. It net results should be exactly the same as we are with LIBOR.
Mark Meloy:
Good. We've touched on some of this, um, already, but what is First Business Bank doing to prepare for the transition away from LIBOR? And what's that timeline look like Ed?
Ed Sloane:
Yeah. So we have a team, a transition team as together on it, uh, you know, marks on, on this, um, Bill, my, myself, we have a couple of other folks from, uh, from senior management that round out the, uh, the transition team. Um, you know, participants in the process go beyond just the, the transition team itself. Obviously the clients impacted, um, but also relationship managers, the operations group, loan, loan operations in particular. And, uh, and you know, members of senior management are involved at certain points in the process.
Ed Sloane:
So, it's, um, as a big cross section of, uh, of first business, um, you know, officers managers that, uh, that, that make up the overall process here. The timeline, you know, carries through what we've been talking about. Mark, you know, out through 2021, um, is, is the likely timeframe around this. And at the end of 2021 is where LIBOR is expected to be discontinued.
Ed Sloane:
We'll obviously be ramping up to that by doing a number of things internally and with the client as we, uh, as we move through the next, uh, the next few quarters. You know, on the client side, uh, I mentioned this a little bit. We actually started back in March of 2019, to, um, adopt or adjust new contracts, new loan contracts for language that relates to the alternative rate index, uh, what I was talking about for, uh, before. So it could be, it could be so for it to be another index that, uh, that could end up being used.
Ed Sloane:
So again, we started that process, you know, well, over a year ago. And now in the fourth quarter of this year, uh, we're starting to look at the existing client loan agreements, to the point that you made earlier, Mark, uh, considering an addendum that, uh, that we could attach to the loan agreement. And, um, and that would have the modifying or fallback language in it.
Ed Sloane:
So, you know, that's something that's gonna be going on here in the fourth quarter, into the first second quarter of next year. Uh, it'll take some time. We have a number of loans that, uh, that need to be addressed. Um, you know, interest rates, swap agreements that, uh, that Bill mentioned earlier, those are, those have a tie into LIBOR, and will require some modificating- modifications as well. Some of the modifying language that I mentioned earlier.
Ed Sloane:
Um, that all these things are important to really expedite the process. And, uh, and then also from a regulatory standpoint, we have guidance that comes out on a regular basis from our regulators, the federal reserve, the FDIC, indicating, um, the need for banks to do this type of planding, planning, and adjustments to, to their, uh, internal loan, loan agreements, et cetera.
Ed Sloane:
Um, we would expect then the final communication, uh, associated with the actual replacement index, uh, to happen later in 2021. And that happens upon the, um, the discontinuance of, of LIBOR. Uh, that's on the client side. So lots of back and forth with the client to, uh, address some of the modifying language that, um, that I'm talking about here. A- as it relates internally to, to the process, you know, we initially created an inventory of products that, uh, that are tied to, to LIBOR.
Ed Sloane:
We're reviewing operating systems for the, the rate calculation that, that Bill mentioned earlier, making sure that, uh, that a different index can be accept- accepted, uh, in place of LIBOR. Uh, looking at third party vendor agreements, and then various risk management considerations, whether that's on the regulatory front, legal, various compliance and disclosure type issues, to, to address it.
Ed Sloane:
So, it is a big undertaking, a lot of things being done with the client, as well as, uh, internally through our transition team.
Mark Meloy:
Yeah, I think, um, that's a really, really good synopsis of, of actions in the plan, but I think suffice it to say for that LIBOR based borrower, if there's a, if there's an addendum, it needs to be executed. There will be an outreach from First Business Bank to them, to get this going. We don't, we don't expect them to you know, scour through their loan documents to make that determination on their own, but that we will, he will proactively be reaching out.
Bill Uelmen:
Yep. That's exactly-
Mark Meloy:
And.
Bill Uelmen:
... Oh, sorry go ahead Mark.
Mark Meloy:
No, I just said, and much of what the purpose of this conversation today is. And other communication is to, is really the idea of education and information to, to help try and answer-
Bill Uelmen:
Okay.
Mark Meloy:
... questions that may come up, that people are gonna hear in conversations. They're gonna hear on the news, they're gonna see on... I see on the Wall Street Journal, or what have you to know that we're, we're moving forward, on their behalf in this way.
Ed Sloane:
Mm-hmm (affirmative).
Mark Meloy:
Is there something else you want to add Ed?
Ed Sloane:
Yeah, I, I, I would just add that, uh, you know, this podcast, of course, uh, we have a Q&A that's available, uh, and I believe Mark that's out on our website, correct? That's correct?
Mark Meloy:
That's correct. Yep.
Ed Sloane:
And then we're also doing some direct mailing, not only to our, our LIBOR type clients, but all clients, just to make them aware of, um, of this transition and, uh, you know, provide some education, uh, around it. So we're touching the client in a, in a number of different ways to, uh, to make sure that there's a good awareness and preparation for, uh, for the transition overall.
Mark Meloy:
Good, thanks. Thanks. Bill anything to add to the, to the conversation?
Bill Uelmen:
And nothing else here. Again, a lot of this is in, in our court and we'll be in communication. We'll be reaching out to clients here very shortly here in the first quarter. And, you know, really our plan is to have everything ready, ready in place by middle of next year. So that by the end of the year, we are ready to go with the transition.
Mark Meloy:
Good, thanks. Well, I wanna thank both of you, Ed and Bill for sharing your thoughts about pending elimination of LIBOR as a base rate. And to all of you, our audience, thanks for listening to our conversation. And as we move closer on the calendar to the eventual elimination of LIBOR, you will hear more and more about it from First Business Bank and from your relationship manager.
Mark Meloy:
There are still a few of our clients with LIBOR based notes that need to execute the addendum. We talked about to ensure a smooth transition, to the new, to the new base rate, that will, that will, uh, I'll be wrapped up in the next few months. So those conversations will, we'll be forthcoming, uh, relatively soon. For most others, your documents are already ready to go. And the only actually remaining is the finalizing of the replacement rate, that First Business Bank will determine at, at future time period.
Mark Meloy:
And of course, for those of you listening that don't have a LIBOR base variable rate note. And you learned a lot about, uh, LIBOR loans and the pending change, but you don't have to do anything at all. We enlightened you a little bit though in that part of the conversation. So, let us know if there are other topics, or information you'd like to learn more about and join us the next time on the First Business Bank podcast.