By John Hintze
The transition away from the London Interbank Offered Rate to a growing menu of replacement rates just got a whole lot easier for banks.Explaining the need to move away from Libor should be easy enough: The interbank-funding rates global banks submit to generate Libor have become too few to support a robust benchmark.
But how to explain moving to a replacement benchmark for which borrowers won’t know their interest-rate payment until a few days before the end of the billing period, instead of at the start? Or to a rate based on data from the last term rather than the current one?
Those have been the options to calculate what have been the two most prominent Libor-replacement rates—the Secured Overnight Financing Rate and Ameribor—and, unsurprisingly, few loans have been priced over them. Borrowers instead want the simplicity of Libor’s structure: A forward-looking term rate in which they know their interest payments at the beginning of the billing period.
To the rescue, American Financial Exchange, which publishes Ameribor, introduced a 30-day term rate in March and launched a 90-day version in May, while the CME announced April 21 publishing term SOFR in one-month, three-month and six-month tenors.
“Most customers are used to having a rate fixed for a month or whatever the billing period is, so they know what their interest payment is going to be,” says Matthew Tyler, corporate treasurer at $85 billion-asset Zions Bancorporation. “We think that for most customers the transition to Ameribor from a one-month Libor will be pretty seamless.”
The new challenge for bankers, in fact, may be explaining to clients that there are now multiple Libor-replacement rates offering forward-looking terms, including the Bloomberg Short-Term Yield Index, or BSBY, and the ICE Bank Yield Index.
Besides Ameribor, Zions will allow customers to reference SOFR where appropriate and is currently educating its bankers about the rates. It has developed a flow chart to help them guide customers to the most suitable rate for their needs, and it is choosing customers for a pilot program to make sure the bank’s systems are prepared for the changeover. For reset periods of one-year and longer, Zions plans to reference the Treasury curve.
Ameribor has gathered a following among midsize and regional banks because it is generated from the rates at which financial institutions are borrowing from other institutions over AFX as well as other sources of bank funding, including commercial paper and certificate-of-deposit rates provided by the DTCC. Those unsecured transactions reflect lenders’ credit risk and, Tyler notes, result in a high correlation with Libor, another plus when explaining the transition to borrowers.
The Bloomberg and ICE reference rates also rely on unsecured bank-funding data, and so incorporate credit risk, too. They are less well known at this point, although Bank of America recently priced $1 billion of six-month notes over one-month BSBY.
SOFR, instead, is generated from overnight repurchase agreement transactions secured by Treasury notes, a gigantic market whose volume exceeds $500 billion. Regulators view that volume favorably because it reduces the likelihood of market manipulation. However, the secured rate is significantly lower than the unsecured ones incorporating credit risk, and it likely will behave differently in times of market stress, potentially resulting in banks’ funding costs exceeding their return on assets.
Scott Shay, chairman and co-founder of $85 billion-asset New York-based Signature Bank, notes the challenge in explaining to borrowers not only how SOFR is generated but why the rate must be adjusted and basis points added to account for credit risk. “If borrowers don’t understand SOFR, they’re really not going to understand the credit-adjustment component,” he explains.
Signature will offer Ameribor and SOFR when necessary, for competitive reasons, Shay said, noting that other Libor-replacement rates currently in the works, such as Bloomberg’s BSBY, also include credit components.
The anticipation currently is the biggest banks and their large corporate customers will choose SOFR, partly because big companies rely on the global financial institutions not only for loans but swaps and other derivatives as well as various treasury-management services. Those same banks participated in the Alternative Reference Rate Committee, sponsored by the New York Fed and of which ABA is a member, that has coordinated the development of SOFR.
Regional and community banks may instead lean toward the unsecured rates. “My expectation is that we will lead with Ameribor, especially for transactions that are not being swapped or require derivatives, since the derivatives market is still developing,” says Reed Whitman, treasurer of Brookline Bank, based in Brookline, Massachusetts.
Borrowers swapping their floating-rate loans to fixed is a common strategy, so their bankers will have to explain why it will be challenging to provide that service for the foreseeable future since derivatives markets today are based on Libor-based contracts.
Banks providing interest-rate swaps will often in turn swap that exposure “back-to-back” with a dealer to remove the basis risk from their balance sheets. Dealers, however, generally seek to mitigate that risk in the futures market, and the futures markets for each of the Libor replacement rates are still nascent. There is significantly more trading in SOFR futures than in those of competitors, potentially giving that benchmark a leg up, but the volume is still minuscule and mainly dealer-to-dealer rather than dealer-to-client.
Whitman says that the variety of forward-looking term rates now available is a “great development” because it means that banks will have a choice when transitioning from Libor. Other developments to look out for, he says, include: robust futures activity and published short-term cash futures rates in tenors of two to five years; dealer liquidity out past five years, enabling the derivatives market to support a longer-term interest rate curve; and commercial banks tying commercial loans to these indexes.
John Hintze is a frequent contributor to the ABA Banking Journal.
