The Canary Wharf headquarters of Barclays Bank, one of multiple banks discovered to be part of a plot to manipulate Libor
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Banks are weighing the relative pros and cons of different short-term interest rates as alternatives to a decades-old benchmark that was recently retired for new loans.
For years, Libor was used by loan issuers as a benchmark for setting interest rates on various financial products. Following investigations that began over a decade ago, regulatory authorities from the U.S. and other countries issued hefty fines on banks accused of manipulating Libor, a scandal that led to its retirement. As a result, multiple replacement benchmark rates have been created.
U.S. regulators recommended in October 2021 that banks stop entering new contracts using Libor by Dec. 31, 2021. It said continuing to do so would create risks to safety and soundness. A group called the Alternative Reference Rates Committee, or ARRC, recommended the secured overnight financing rate, as an alternative to Libor in July 2021. The ARRC consists of private market participants and is convened by the Federal Reserve Board and the Federal Reserve Bank of New York.
Unlike Libor, Sofr is backed by U.S. Treasury bonds and is, therefore, a nearly risk-free rate. However, banks, especially regional ones, might sometimes prefer a rate that is more credit-sensitive, meaning it reflects the costs or the risks of unsecured borrowing, in order to protect lending margins in times of market stress.
"There's a lot of analysis going on and thinking going on about which rates banks want to use and migrate to," Barry Barretta, managing director at EY, said in an interview. "It's been an ongoing debate for well over a year and a half, but it's really starting to heat up now that Libor's gone away for new transactions."
Ameribor and the Bloomberg Short Term Bank Yield Index, or BSBY, are two recently created unsecured, credit-sensitive rates. Unlike Sofr, they have a built-in dynamic credit spread, which is the yield difference between a U.S. Treasury bond and another debt security with the same maturity.
Banks using Sofr are applying a static credit spread that "may not reflect their long-term funding cost or changes that occur at the time a specific line of credit is drawn upon, which may be better reflected in Ameribor and BSBY," said Peter Torrente, KPMG's national sector leader of banking and capital markets.
Using credit-sensitive rates can help during times of economic stress.
"Generally in worsening economic environments, banks' cost of funds rise," Justin Keane, consulting solutions principal at PwC, said in an interview. "So if you are indexed to a rate that is credit-sensitive, your revenue stream on your assets rises as your funding costs go up."
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Sofr advantages
One of the reasons Sofr is seen as a safe, reliable alternative to Libor is the depth and breadth of the transactions upon which it is based.
"There's sort of inherent skepticism about a rate that has been based on a relatively small number of transactions but is carrying the weight of a huge amount of reference transactions, if you will," Jane O'Brien, partner at Paul Weiss Rifkind Wharton & Garrison LLP, said in an interview. "I think that was really perceived to be the fundamental flaw with Libor. ... The volume of transactions that go into calculating Sofr is so enormous that there's a comfort that it's based on real, identifiable transactions as opposed to more speculative, a small number of transactions."
Varying fallback provisions
Some older contracts that used Libor might have less robust fallback provisions for using alternative rates.
In December 2021, the U.S. House of Representatives passed a bill that would direct the Federal Reserve Board of Governors to choose a replacement rate for contracts that lack fallback provisions or if a replacement rate is not selected. The Senate has not taken action on the legislation. Sens. Thom Tillis, R-N.C., and Jon Tester, D-Mt., are drafting the Senate version of the legislation, said Adam Webb, spokesperson for Tillis. Roy Loewenstein, spokesperson for Tester, confirmed.
When there are refinance renewals, it would make sense to move to a new contract with a new rate before Libor stops being published, Keane said.
Loans issued in the recent past have particularly robust fallback provisions that are aligned with ARRC recommendations, so it is clear what will happen to those loans, said Alexey Surkov, partner at Deloitte and co-chair of ARRC's Operations and Infrastructure Working Group. Banks will transition to the alternative rate in the fallback provision of the loan.
"There's still a fair amount of legacy positions out there, although obviously a lot fewer now," Surkov said in an interview. "The fallback provisions may be less robust." For example, they might have a fallback provision for situations in which Libor is not published on a given day.
"Perhaps there are questions or some uncertainty as to what happens to the rates and those loans after that point in time," when Libor is no longer published, Surkov added.
Most contracts with fallback language will continue until June 2023, when Libor will stop being published, said Torrente.
"There is still a large amount of back-book remediation and client outreach for aged legacy contracts which will be addressed over [the] next 17 months through remediation or transition to alternate reference rates," Torrente added.
Making the transition
Most banks have developed transition plans, and many have given flexibility for replacing Libor, whereas some have decided to negotiate amendments with borrowers, said Matthew Tevis, global head of financial institutions at Chatham Financial.
"For those Libor-based loans that have been swapped, our bank clients are focused on minimizing any future rate differences between the loans and related hedges," Tevis added. "That approach may involve amending the underlying loan agreement to match the fallback Sofr rate used as part of the [International Swaps and Derivatives Association] protocol."
Technological and infrastructure changes are expected to be the focus in the next year and a half, Surkov said.
Systems, processes, risk management, hedging and more will be affected, Keane said. One example is having to adjust to using an overnight rate rather than an interbank term borrowing rate.
"There's still a lot of work to do," Keane said. "We haven't really made a dent in the existing transactions."
David Hayes contributed to this report.