After years of preparation, banks saw a smooth transition to SOFR and other alternative rates.
By John Hintze
The long but critical transition away from Libor to a replacement rate benchmark drew to a close in June. U.S. regional banks saw a smooth transition to the Secured Overnight Financing Rate and alternatives.
Since June 30, Libor has been consigned to the history books, and virtually all existing transactions priced over the benchmark transitioned to replacement rates. New floating-rate transactions have had to price over a replacement rate since the start of 2022, but a vast ocean of transactions that were originated before that date either refinanced to a replacement rate or “fell back” to an appropriate replacement upon Libor’s cessation by contract.
In 2014, the Federal Reserve established the Alternative Reference Rates Committee, led by representatives from the largest financial institutions, to identify a Libor-replacement rate and guide its development. It chose SOFR, generated from transactions in the gigantic overnight repurchase-agreement market, in 2017.
Some market participants expressed concern about the risk-free nature of SOFR, collateralized by U.S. Treasury notes, worried it would fall in periods of financial-market stress as investors sought safety while credit concerns increased lenders’ funding costs. These banks were also worried about calculating interest payments from the overnight rate, and the uncertainties that created for both lenders and borrowers.
Regional banks’ attentions thus turned to the American Financial Exchange’s Ameribor and the Bloomberg Short-Term Bank Yield index. Both incorporate bank credit risk and so should increase alongside bank funding costs in times of market stress. They also adopted the term structures that banks and their borrowers were accustomed to.
Nevertheless, after the ARRC’s approval of the CME Group’s term SOFR rates in July 2021, market support consolidated behind SOFR. The term structure, similar to Libor’s, informs borrowers of their interest-rate payments due in 30 days or whatever the term length is. Prior to term SOFR, interest payments had to be calculated either by averaging or compounding daily SOFR until a few days before the payment due date, or averaging or compounding daily SOFR over the previous interest period to determine the rate for the subsequent period.
Explaining those complex calculations to customers and the risks involved was problematic, and the arrival of term SOFR was a relief. “We chose term SOFR as our fallback index,” says Joseph Swarr, loan operations systems manager at Customers Bank, a regional institution with more than $20 billion in assets, “because it seems the most like Libor, with the same functionality and statement timings.”
The ARRC recommended term SOFR as the primary fallback rate for commercial loans upon Libor’s cessation. But it is not a requirement, and banks have been reviewing their legacy loans to determine if the existing fallback language is appropriate. If loans were originated before the ARRC’s term SOFR recommendation, their fallback language typically transitions them to daily SOFR or perhaps prime or another rate. Considering customers’ best interests, that fallback language may have to be amended before June 3, if it has not been already.
A small percentage of legacy Libor loans had no or limited fallback language. The Libor Act passed in 2022 and implemented by the Federal Reserve in December 2022 automatically transitioned those loans to term SOFR plus an adjustment to account for the difference between the two indexes.
Some banks still prefer moving clients to a replacement rate that more closely resembles Libor. ServisFirst Bank, headquartered in Birmingham, Alabama, offers commercial clients a choice of SOFR, the prime rate, or Ameribor. “When we’ve explained Ameribor to customers and how it is calculated, and that it’s an overnight unsecured rate — not a secured rate — they’re comfortable with it,” says Rodney Rushing, COO of ServisFirst, a business-oriented bank with $14 billion in assets.
Most of Zions Bank’s commercial loans had either already transitioned to a replacement rate or they had fallback language that transitioned them at Libor’s cessation, says Matthew Tyler, treasurer at the Salt Lake City-headquartered regional bank. Most customers chose term SOFR for new loans, and it has also been the preferred index for the legacy loans in which Zions has worked with customers to amend fallback language.
“We’ve been pushing Ameribor and BSBY for loans we negotiate bilaterally with customers, but we haven’t prevented them from choosing SOFR,” Tyler says.
One issue that’s still unfolding is the ARRC’s approval of term SOFR only for commercial loans and some floating-rate consumer loans, and until recently only for derivatives directly hedging those products. Consequently, when a bank facilitates a swap between a commercial client seeking to pay fixed and received floating-interest payments and a swap-dealer counterparty, the dealer can’t lay off that risk by entering into a swap with another dealer.
As a result, exposure to term-SOFR risk has built up on swap dealers’ balance sheets, Tyler said, and those swaps now cost approximately two basis points more than swaps referencing overnight SOFR.
That cost can vary from bank to bank. Amol Dhargalkar, managing partner and head of Chatham Financial’s corporate sector, says dealers are now charging up to six to eight basis points for hedges compared to two or three previously. “Companies don’t want to house that basis risk on their balance sheets, to be worried about whether term SOFR is going to be different than what average daily SOFR was over that one-month or three-month period,” Dhargalkar says. “So they’ve been willing to pay the premium.”
The ARRC denounced the use of term SOFR derivatives to avoid a decline in trading of overnight SOFR futures, on which term SOFR is based. To provide some relief to dealers, the ARRC recommended in April that dealers could hedge basis risk with nondealer counterparties, such as hedge funds and asset managers.
“While not as helpful as allowing inter-dealer trading of term SOFR basis swaps, allowing some type of market to exist can help stabilize and potentially reduce the growing term SOFR premium that companies have faced over the past several months,” Dhargalkar says.
John Hintze is a frequent contributor to the ABA Banking Journal.
