How to deal with LIBOR instability warnings? Stop using the benchmark rate, Quarles says

Warnings about the growing instability of an international benchmark interest rate for short-term, interbank loans should be taken seriously, the Federal Reserve’s top supervisor said Monday, leading to at least one conclusion: stop using it.

In a videotaped message, Federal Reserve Board Vice Chairman for Supervision Randal Quarles said not everyone has paid attention to warnings, issued since at least 2014, that the London Interbank Offered Rate (LIBOR) could become unstable.

“My key message to you today is that you should take the warnings seriously,” Quarles said in the message taped for the Alternative Reference Rates Committee’s (ARRC) fourth roundtable, held in New York City. “Clarity on the exact timing and nature of the LIBOR stop is still to come, but the regulator of LIBOR has said that it is a matter of how LIBOR will end rather than if it will end, and it is hard to see how one could be clearer than that,” Quarles said. (ARRC is a group of private-market participants convened by the Fed to shepherd the transition from U.S. dollar LIBOR to an alternative, which the group calls the Secured Overnight Financing Rate [SOFR]).

Quarles, noting that “guaranteed stability” for LIBOR has only 30 months left (after which some groups have said they would no longer use the benchmark rate), said the transition should begin happening in earnest. “I believe that the ARRC has chosen the most viable path forward and that most will benefit from following it, but regardless of how you choose to transition, beginning that transition now would be consistent with prudent risk management and the duty that you owe to your shareholders and clients,” Quarles said.

Quarles also noted that ARRC and others have developed “fallback language” for use with new issuance of cash products that refer to LIBOR. “It seems clear that much of the contract language being used currently did not envisage and is not designed for a permanent end to LIBOR,” Quarles said. “The ARRC’s fallback recommendations represent a significant body of work on the part of a wide set of market participants and set out a robust and well-considered set of steps that expressly consider an end to LIBOR,” he added, urging “everyone to avail themselves of this work.”

But, Quarles added, there is an easier path – simply stop using LIBOR.

“At this moment, many seem to take comfort in continuing to use LIBOR – it is familiar, and it remains liquid,” Quarles said. “But history may not view that decision kindly; after LIBOR stops, it may be fairly difficult to explain to those who may ask exactly why it made sense to continue using a rate that you had been clearly informed had such significant risks attached to it.”

The Fed’s top supervisor said simply relying on fallback language to transition brings operational and economic risks. “Firms should be incorporating these factors into their projected cost of continuing to use LIBOR, and investors and borrowers should consider them when they are offered LIBOR instruments. If you do consider these factors, then I believe you will see that it is in your interest to move away from LIBOR,” he said.

Quarles also offered clarifying words about the Fed’s supervisory stress tests and the use of SOFR as an alternative to LIBOR. He noted that supervisory projections of net interest income, used in the stress tests, are primarily based on models that implicitly assume that other rates such as LIBOR or SOFR move passively with short-term Treasury rates. “Given these mechanics, choosing to lend at SOFR rather than LIBOR will not result in lower projections of net interest income under stress in the stress-test calculations of the Federal Reserve,” he said.

Federal Reserve Vice Chair for Supervision Randal K. Quarles video message: The Next Stage in the LIBOR Transition