ABA Banking Journal
No Result
View All Result
  • Topics
    • Ag Banking
    • Commercial Lending
    • Community Banking
    • Compliance and Risk
    • Cybersecurity
    • Economy
    • Human Resources
    • Insurance
    • Legal
    • Mortgage
    • Mutual Funds
    • Payments
    • Policy
    • Retail and Marketing
    • Tax and Accounting
    • Technology
    • Wealth Management
  • Newsbytes
  • Podcasts
  • Magazine
    • Subscribe
    • Advertise
    • Magazine Archive
    • Newsletter Archive
    • Podcast Archive
    • Sponsored Content Archive
SUBSCRIBE
ABA Banking Journal
  • Topics
    • Ag Banking
    • Commercial Lending
    • Community Banking
    • Compliance and Risk
    • Cybersecurity
    • Economy
    • Human Resources
    • Insurance
    • Legal
    • Mortgage
    • Mutual Funds
    • Payments
    • Policy
    • Retail and Marketing
    • Tax and Accounting
    • Technology
    • Wealth Management
  • Newsbytes
  • Podcasts
  • Magazine
    • Subscribe
    • Advertise
    • Magazine Archive
    • Newsletter Archive
    • Podcast Archive
    • Sponsored Content Archive
No Result
View All Result
No Result
View All Result
ADVERTISEMENT
Home Commercial Lending

From Libor to SOFR

February 21, 2018
Reading Time: 7 mins read

By Barry Mills

There has been a lot in the financial press recently about Libor—the London interbank offered rate—and efforts to identify and implement alternatives to Libor. A measure of the rate at which large banks can borrow from one another on an unsecured basis, Libor is a reference rate underpinning more than $350 trillion in mortgages, commercial loans, bonds and derivatives. Reference rates serve an important purpose in that they reduce search costs and improve the ability of customers to compare pricing. With the publication of a reference rate such as Libor, bank customers are better able to judge whether the rate being charged is competitive.

In 2014, the Federal Reserve convened the Alternative Reference Rates Committee to identify a set of alternative reference interest rates that are more firmly based on actual transactions. Not only has Libor been subject to manipulation by market participants, but U.S. and other global regulators have become worried that with fewer banks borrowing in an unsecured fashion, the robustness and reliability of Libor is questionable. While significant improvements have been made to Libor, the U.K.-based Libor regulator has indicated that it will no longer utilize its regulatory authority to compel banks to submit to Libor. “Libor may remain viable well past 2021, but we do not think that market participants can safely assume that it will,” says Federal Reserve Board Chairman Jerome Powell.

How Libor came to be

In order to understand what the potential discontinuation of Libor and the adoption of a new rate might mean, it’s important to understand the genesis of Libor and how it became so prolific in financial contracts. Minos Zombanakis—a Greek-born banker who worked for U.S.-based banks in London—devised Libor in 1969 when he arranged an $80 million loan for the cash-strapped shah of Iran. Importantly, the loan was one of the first that could be split up among banks and charge a variable rate of interest to reflect changing market conditions. Loans in which multiple banks hold a share of a loan are called “syndicated loans.”

Zombanakis stated that he wasn’t looking to break new ground in the financial space but rather was simply trying to find a rate on which all of the syndicated loan participants could agree. At the time that Zombanakis created Libor, London was increasingly a global financial hub as Russia, China, and many Arab states chose to bank in Britain rather than the U.S. out of fear of confiscation. London also benefitted from U.S. regulations that effectively capped the amount of interest American banks could pay on deposits.

Zombanakis knew that no single firm would be willing to lend $80 million to a developing country, particularly at a rate that was fixed. U.K. interest rates at this time were 8 percent and inflation was on the rise. Banks generally are wary of lending at fixed rates for long periods of time when interest rates are expected to rise due to inflation. Variable rates loans help banks mitigate this risk since the interest rate payment that they receive fluctuates with prevailing market interest rates, which generally increase as inflation expectations increase. But how would Zombanakis decide on a variable rate upon which all banks that were involved in the syndicated loan could agree?

The solution that Zombanakis came up with was to charge borrowers an interest rate that would be recalculated every few months. The banks in the syndicate would report their unsecured funding costs right before the new rate adjustment period and this would serve as the basis for the variable interest rate charged to the customer. This way, changes to the interest rate received from customers on variable rate loans—with Libor as the reference rate—would roughly move in tandem with changes in rates associated with the syndicate banks’ own funding costs. With this invention, banks were more likely to participate in large syndicated loans so that their earnings associated with the syndicated loan wouldn’t be buffeted by changes in interest rates.

Before long, Libor became the basis for floating rate bonds and interest rate swaps, which allow companies to manage risk that arises from changing interest rates. Libor was adopted because it was perceived to be a simple and independent approximate measure of bank borrowing cost and, therefore, a candidate for a wide variety of variable rate loans. Indeed, the use of Libor in financial contracts of many types, including mortgages and student loans, proliferated.

Libor’s value for banks

A commercial bank making a longer-term variable rate loan while also funding itself with variable rate short-term borrowings will be affected by movements in both the general level of interest rates and the bank’s credit spreads (i.e., the cost of bank borrowing that is over and above general interest rates). If a bank were to use a Treasury note rate—generally perceived to be an approximation of a risk-free rate—as its reference rate in loan contracts, then the bank has only hedged the part of its funding costs that is associated with general movements in interest rates. If the spread at which the bank can fund itself widens relative to the risk-free rate serving as the reference rate in its lending contracts, then the bank’s net interest margin—or the difference between the interest earned on its loans and the interest that it pays on its borrowings—will suffer.

If instead the loan uses Libor as a reference rate, then the bank will also hedge market-wide bank credit risk. Being able to hedge market-wide bank credit spreads is important because, as was seen in the 2007-2009 crisis, Libor rates increased several percent while Treasury rates declined. The very fact that Libor could be used to hedge bank credit risk likely explains its expanded use in a variety of lending contexts.

While Libor’s use in loans is widespread, its prevalence in loans is vastly overshadowed by its use in interest rate derivatives. Indeed, interest rate derivatives account for nearly 90 percent of the outstanding gross notional value of financial products referencing Libor. While there is a strong case for the use of Libor for hedging a bank’s loan funding costs, it is unlikely that users of interest rate derivatives have an underlying motivation to hedge bank credit risk. Instead, users of interest rate derivatives tied to Libor prefer Libor as a means to hedge general interest rate risk.

Why then do users of interest rate derivatives rely on derivatives that are Libor-dependent if derivative users do not care about hedging bank credit risk? The answer is that the market for Libor-based derivatives is tremendously deep and liquid. The very fact that Libor is so prevalent in derivative contracts makes it that more challenging to switch to an alternative reference rate, even if that alternative would be preferable in that it does not contain bank credit risk.

If one were able to start from scratch, an ideal world would potentially involve two reference rates: one that would approximate to bank funding costs that could be used in bank loans and banking-oriented derivatives to hedge bank market-wide bank funding cost and a second reference rate that would be a riskless or near-riskless rate that would allow interest rate derivative-users the ability to more purely hedge movements in general interest rates without having to worry about movements in bank credit spreads.

SOFR and the path forward

As mentioned before, the continued publication of Libor is not guaranteed, and, therefore, Libor alternatives need to be considered. To effectuate implementation of a Libor alternative, one would need a deep and liquid market for the alternative rate or rates. Indeed, the criteria used by the ARRC when selecting an alternative to Libor for use in new derivative and other financial contracts included ensuring that the chosen rate has a deep underlying market that is robust over time. As Powell has said, “there would be no point in selecting a rate that might find itself quickly in the same kinds of conditions that Libor is in now.”

The ARRC has selected the Secured Overnight Funding Rate, a broad measure of overnight Treasury financing transactions as its recommended replacement for U.S. dollar Libor. The Federal Reserve will begin publication of SOFR in the second quarter of 2018. The ARRC has stated that the SOFR is the most robust rate available with underlying transactions of about $700 billion per day or more, much larger than the volumes associated with other potential Libor alternatives.

While the advantages of a robust reference rate are clear, SOFR has two distinct challenges relative to its suitability for lending arrangements. First, SOFR is a secured rate while Libor is an unsecured rate. This is important because Libor was originally developed to be and continues to serve as an approximation of a bank’s unsecured borrowing costs. Generally, secured borrowing rates are lower than unsecured rates because secured borrowings are backed by collateral. Thus, Libor will generally be higher than SOFR. Indeed, SOFR transactions involve Treasury securities as collateral. Second, SOFR is an overnight rate only, while U.S. dollar Libor is currently published according to the following tenors: overnight, one week, one month, two months, three months, six months and one year. Generally, longer-tenor instruments (e.g., one-year Libor) have higher borrowing costs than shorter-tenor instruments (e.g., an overnight rate). On the second challenge, the ARRC has announced that its paced transition plan includes the creation of a term reference rate based on SOFR derivatives once sufficient liquidity has been established.

Thus, the ARRC has come up with a potential solution—assuming sufficient liquidity is developed—to addressing the term structure challenge that SOFR poses, but the lack of bank credit risk in SOFR remains an unresolved issue. “Stakeholders in legacy loans may seek to include some form of a credit spread that incorporates the Libor-SOFR differential when Libor is discontinued into their interest rate calculations,” said the Loan Syndications and Trading Association in a comment letter.

The ARRC is also charged with devising plans for a voluntary transition that encourages the use of its recommended rate. One of the most complicated issues involves legacy contracts that reference Libor but do not have strong language in place if Libor were to discontinue publication. Initial reviews of loan documentation suggest that so-called fallback language regarding Libor alternatives—that is, how the contract addresses what happens if Libor is discontinued—may vary across institutions and products presenting challenges for industry-wide adoption of a Libor alternative. “While there may be no perfect contract language or fallback, good risk management requires that we work together to find language and fallbacks that are robust and that limit unintended valuation changes,” Powell says.

Next Steps

  • The work of the ARRC, which has to date encompassed recommending the SOFR and addressing preliminary implementation considerations for derivatives, will soon be summarized in a report.
  • The ARRC has announced that it will be reconstituted to more directly facilitate issues regarding contract robustness for loans, floating rate notes, and securitizations, as well as derivatives.
  • ABA is forming a working group to hold preliminary discussions regarding implementation considerations for loans, floating rate notes, and securitizations. Potential topics for discussion include the effects of a phased transition from Libor in legacy contracts and considerations for addressing Libor alternatives in new contracts. Working group participants may include loan officers, credit officers, in-house legal counsel, regulatory or compliance staff, risk managers, and financial function staff, among other potential interested roles. Please contact Barry Mills if you are interested in joining the working group or would like to learn more.

ADVERTISEMENT
Tags: DerivativesLiborReference rates
ShareTweetPin

Related Posts

ABA, trade groups file reply brief in support of motion for preliminary injunction in 1071 litigation

Banking groups urge regulators to prioritize indexing of supervisory asset thresholds

Newsbytes
July 1, 2025

ABA, along with 52 banking trade associations, sent a letter urging leaders at the Federal Reserve, Office of the Comptroller of the Currency and the FDIC to prioritize the indexing of supervisory asset thresholds.

ABA to DOL: Exclude HSAs from coverage under the fiduciary rule

ABA expert: Time to end HSA ban for Social Security recipients

Newsbytes
July 1, 2025

The House version of the tax package included a provision to restore HSA eligibility for working seniors enrolled in Medicare Part A. Early Senate drafts left it out, but after strong advocacy from consumer groups and healthcare stakeholders...

House-Passed Defense Bill Includes SAFE Banking Act

ABA, state associations support tax provisions in budget bill

Newsbytes
June 29, 2025

Provisions welcomed by ABA and the state associations include a narrow version of the ACRE Act and a permanent Section 199A deduction that levels the playing field for Subchapter S banks.

Green Dot agrees to pay Federal Reserve $44 Million to resolve UDAP allegations.

Fed: Large banks remain ‘well positioned’ to withstand severe downturn

Economy
June 27, 2025

Under the recession scenario, the CET1 capital ratio declined by 1.8 percentage points in the aggregate. The Fed has proposed averaging results over multiple years to reduce volatility in calculating capital requirements.

Banking agencies seek public input on capital standards for large banks

Banking agencies seek public input on capital standards for large banks

Newsbytes
June 27, 2025

The Fed, FDIC and OCC issued a joint request for comment on a proposal to modify certain regulatory capital standards for large banks. Comments are due Aug. 25.

BIS: Stablecoins fail as ‘sound money’

BIS: Stablecoins fail as ‘sound money’

Compliance and Risk
June 27, 2025

Stablecoins as a form of sound money fall short, and without regulation pose a risk to financial stability and monetary sovereignty, according to a recent report by the Bank for International Settlements.

NEWSBYTES

HUD rescinds several regulatory requirements for FHA-backed mortgages

July 1, 2025

Louisiana-based Investar inks deal for Wichita Falls Bancshares in Texas

July 1, 2025

Banking groups urge regulators to prioritize indexing of supervisory asset thresholds

July 1, 2025

SPONSORED CONTENT

Navigating Disruption in Ag Lending – Why Tariffs Are Just the Tip of the Iceberg

Navigating Disruption in Ag Lending – Why Tariffs Are Just the Tip of the Iceberg

July 1, 2025
AI Compliance and Regulation: What Financial Institutions Need to Know

Unlocking Deposit Growth: How Financial Institutions Can Activate Data for Precision Cross-Sell

June 1, 2025
Choosing the Right Account Opening Platform: 10 Key Considerations for Long-Term Success

Choosing the Right Account Opening Platform: 10 Key Considerations for Long-Term Success

April 25, 2025
Outsourcing: Getting to Go/No-Go

Outsourcing: Getting to Go/No-Go

April 5, 2025

PODCASTS

Podcast: Inside ABA’s new Treasury Check Verification System API

June 25, 2025

Podcast: Staying close to clients amid tariff-driven volatility

June 18, 2025

Podcast: Old National’s Jim Ryan on the things that really matter

June 12, 2025
ADVERTISEMENT

American Bankers Association
1333 New Hampshire Ave NW
Washington, DC 20036
1-800-BANKERS (800-226-5377)
www.aba.com
About ABA
Privacy Policy
Contact ABA

ABA Banking Journal
About ABA Banking Journal
Media Kit
Advertising
Subscribe

© 2025 American Bankers Association. All rights reserved.

No Result
View All Result
  • Topics
    • Ag Banking
    • Commercial Lending
    • Community Banking
    • Compliance and Risk
    • Cybersecurity
    • Economy
    • Human Resources
    • Insurance
    • Legal
    • Mortgage
    • Mutual Funds
    • Payments
    • Policy
    • Retail and Marketing
    • Tax and Accounting
    • Technology
    • Wealth Management
  • Newsbytes
  • Podcasts
  • Magazine
    • Subscribe
    • Advertise
    • Magazine Archive
    • Newsletter Archive
    • Podcast Archive
    • Sponsored Content Archive

© 2025 American Bankers Association. All rights reserved.