Ironing Out the Wrinkles in the Post-Libor Landscape

By John Hintze

In March 2021, the administrator of the London Interbank Offered Rate made it official: certain tenors of U.S. dollar Libor would cease to publish on Dec. 31, 2021, with remaining settings terminating on June 30, 2023, for legacy transactions. With the long-telegraphed Libor endgame now set in stone, banks are picking up the pace of transition amid front- and back-end challenges.

One concern held by community, midsize and regional banks that use Libor is that the Secured Overnight Financing Rate, the favored alternative of the Alternative Reference Rate Committee, a public-private group convened by the New York Fed, is that it does not reflect credit risk. In times of market stress, investors flocking to the risk-free rate would cause it to plummet, along with the banks’ returns on SOFR-priced loans, while their cost of funds jumps—a bank nightmare.

The ICE Benchmark Administration, which currently administers Libor, was the first to propose a credit spread derived from a range of bank funding transactions that could rest on top of SOFR to incorporate credit risk. Bloomberg and IHS Markit are working on similar solutions.

Matthew Tevis, managing partner, board member and global head of financial institutions at Kennett Square, Pennsylvania-headquartered Chatham Financial, says banks are planning to provide SOFR-priced loans, but some are considering shifting their books to the well-established Prime or fed funds rates. Others, he adds, are already using the American Financial Exchange’s Ameribor, a replacement rate that incorporates credit risk because it is generated by lenders’ interbank funding through AFX.

Despite having the regulators’ implicit approval, SOFR has to date been used primarily by government-sponsored enterprises and the largest banks. Community and regional banks have priced some commercial loans over Ameribor, limited by the operational changes required to support the new index. More bond offerings and derivatives have been structured using SOFR, but far from the consistent level implying a market benchmark.

“We’ve not yet seen the wholesale movement that might have been expected,” Tevis explains.

Nevertheless, that shift is anticipated soon, requiring banks to process new transactions using any of an array of Libor replacement-rate alternatives, including several methods to calculate SOFR that each require significant operational heft. That leaves less than 10 months to finalize changes to policies and procedures and systems as well as educate customers about new rates that function very differently from those they’re accustomed to.

“Bank supervisors and examiners are expecting banks to get very serious about not just developing a transition plan but moving down the road,” says Hu Benton, VP for banking policy at ABA and an ARRC member and working group co-chair.

The IBA originally scheduled USD Libor’s cessation for the end of 2021. The extension through June 30, 2023, for several popular Libor tenors, including one-month and three-month USD Libor, provides more time for existing transactions to expire or to adjust their contractual language to switch to a replacement. Despite the relief, time is running out to prepare for new cash products and derivatives.

“Banking regulators have said the market should start doing non-Libor loans as soon as practicable and no later than the end of this year,” says Meredith Coffey, EVP and co-head of public policy at the Loan Syndications and Trading Association, also an ARRC member and working group co-chair. “Nine months isn’t much time to turn a supertanker,” with $223 trillion of contracts outstanding.

Corporate borrowers strongly favor developing a forward-looking term SOFR that functions similarly to Libor today. That would facilitate the transition to a new rate in terms of adapting systems and, more importantly, enable them to forecast their cash positions more accurately. However, it remains far from certain whether such a term rate can be developed for SOFR, which generated from secured, overnight repurchase-agreement (repo) transactions. That forward look depends on developing highly liquid SOFR futures and swap markets, which today remain anemic compared to those used to project the Libor interest-rate curve. And in March, the ARRC said it will not be in a position to recommend a forward-looking SOFR term rate before the end of 2021.

Market observers anticipate more transactions pricing over SOFR now that the Libor cessation dates are finalized. The ARRC’s recommendation to end pricing syndicated loans over Libor by June 30 also increases pressure.

Some regional banks, including Birmingham, Alabama’s ServisFirst Bank, started pricing commercial loans over Ameribor last year, and Chatham Financial priced the first Ameribor-indexed interest-rate swap for Muncie, Indiana-headquartered First Merchants Corp. last December. Currently, major swap dealers, including Citi, are adapting their systems to act as counterparties for Ameribor swaps.

Complicating matters, while SOFR and Ameribor do not yet offer forward-looking term rates, they both have developed several ways to provide term financing, whether one month, three months or another time period. Those methods, however, take simple or compounded averages of the overnight rate over those periods, accruals that are operationally more burdensome than simply plugging in Libor’s future interest payment. And they both require calculation maneuvers that both banks and their clients find problematic compared to Libor’s clean and simple future interest-rate payment.

The variety of replacement rates and calculation methodologies presents a major operational challenge for banks that must adapt their systems by year-end to process new transactions or have temporary solutions in place until that’s completed. Just as important, their staff must be trained to explain to clients why straightforward Libor will no longer be available and how the replacement rates work.

Brookline Bank, a founding member of AFX when it was launched five years ago, began preparing for the transition three years ago, according to bank treasurer Reed Whitman, who says the bank first identified its Libor exposures and presented its findings to management and the board. About 18 months ago it developed contractual language enabling transactions priced over Libor to fall back to a replacement rate and soon after began reaching out to clients to “repaper” their loans.

“We were ahead of the game, but for many borrowers this is just coming on to their radars, and many banks have yet to start the process with customers,” Whitman says.

Jurisdictions worldwide are transitioning away from their specific interbank offering rates to differently structured replacement rates and on different timetables, another issue to consider for banks and corporates that may have exposure to those rates. The U.K. is furthest ahead, pushing for all new transactions to be priced over the Sterling Overnight Interbank Average, or SONIA, rate by the end of this quarter, providing insight into challenges that may lie ahead in the U.S. market.

“The banks’ single biggest challenge is supporting their clients through the transition, since corporates ultimately have to prepare for it themselves operationally,” and small and midsize companies are often behind, says Ed Moorby, who heads up Deloitte UK’s regulatory-change delivery team.

SONIA is an unsecured overnight rate and thus not forward-looking. At the insistence of companies without the resources of large multinationals, regulators have allowed for forward-looking term rates, known as term SONIA reference rates, Moorby said, but they have restricted their to certain circumstances and expect them to be more expensive than the overnight version, so use of them will dwindle over time.

U.S. banks must explain to clients that while a forward-looking term rate may eventually emerge for SOFR and Ameribor, in the meantime they must choose an alternative, including the various methodologies to calculate SOFR and Ameribor—possibly opening up the bank to conduct risk.

“Making sure clients understand the product and establishing it is appropriate for them becomes more difficult when there’s a bigger book of products,” Moorby said.

The LSTA’s Coffey notes that the ARRC’s most recent fallback language for syndicated loans lists a forward-looking term as the first choice, and should that not be available the second choice is simple daily SOFR in arrears. The compounded-in-arrears version of SOFR is marginally more precise but far more complicated to calculate, a key consideration for banks given the time constraints they face. The LSTA in conjunction with the ARRC has defined the conventions, systems and documentation for each of these methods, and can apply them to credit sensitive should they emerge.

The in-arrears methods average the current overnight rates until an agreed upon number of days before the end of the term when the final rate becomes known, giving borrowers at least a few days notice of their upcoming interest payment. Simple and compounded versions of SOFR can also be calculated in advance. It gives borrowers their interest payment at the start of the term, similar to Libor, but is based on averages of the overnight rate over the previous period in question, raising concerns that the rate reflects the current economic environment poorly.

Nevertheless, borrowers have different needs and may opt for a methodology other than the ARRC’s recommendation, or one of the other replacement benchmarks, and banks should be prepared.

“As the market is trying to figure out which rates are best to use, banks may need to offer a lot of these indices to be competitive,” says Tevis at Chatham Financial, adding that the several methods in the works to layer credit spreads on top of the RFRs may add another layer of complexity to explain.

And banks offering customers an array of replacement benchmarks must also be able to process those transactions. The largest banks, many of which participated in ARRC committees to develop SOFR, have the resources and technical expertise to prepare themselves. Smaller banks rely on core processors.

Alexey Surkov, a partner with Deloitte Risk and Financial Advisory and an ARRC working group co-chair, says few concerns have emerged about vendor readiness for the transition, but even if vendors have updated their software, banks still face significant work ahead. “It’s not just upgrading one system but the entire bank ecosystem, which includes various internally developed systems and vendor systems, various databases and pipes that connect them from a dataflow perspective.”

Robert Marinaro, head of product for credit at Allvue Systems, adds that bank systems may date back decades, vendor systems may be proprietary, and the mix in each bank can be bespoke. “And banks add a level of complexity, given the regulatory requirements and pre-approval they have to go through to make changes.”

John Hintze is a freelance writer whose work has appeared in Asset Securitization Report, National Mortgage News, CFO, the Global Association of Risk Professionals’ Risk Intelligence and other business outlets.