"2000 Zero-Zero Party Over Oops Out of Time. So Tonight I'm Gonna Party Like It's 1999." -Prince
For many of us, those words and that song might have been the last we heard on New Year’s Eve in 1999, almost two decades after its initial release. And it seemed like it was the end of a long saga for financial institutions. Despite all the “Y2K” noise leading up to 1999, there was a push at the very end that added a lot of stress.
“LIBOR cessation” seems like the new “Y2K.” While Prince gave us a 20-year head start on 1999, the regulatory community has also given us fair warning that the cessation could have a number of consequences that, if not prepared, could be problematic if dealt with at the last minute. In extending the end of the cessation timeline from the end of this year to June 2023 (along with some strong words), it seems clear they are unhappy with the progress made to date and expect better responses when they ask “So what have you done?”
How prepared is your bank or credit union? The answer should be broken into two responses, in my opinion.
The first is related to how day one impacts your balance sheet and operations in June of 2023.
The second is how it impacts your operations going forward. More to the point, has your team given the questions of “How ?" and Why?” when choosing rate indices the time they truly deserve?
From the Editor
For some, the “end” of LIBOR is a non-event. For others, it’s a more complicated issue, necessitating deeper assessment into what the best solution for your institution really is.
And the clock is ticking…
In the past week, the CTFC (Commodities Futures Trading Commission) told brokers who facilitate derivative trades among large banks to cease the utilization of LIBOR as the reference rate in all deals by July 26th.
While just a recommendation, the guidance effectively has been issued to prompt market participants to start adopting alternatives. For those who may be “late to the game,” this is the perfect time to familiarize your institution with SOFR, Ameribor, or the Bloomberg Short Term Bank Yield Index.
In the June Bulletin, Jeff Reynolds outlines the pros and cons associated with each of the aforementioned replacement indices. Jeff details a number of key considerations bankers need to make prior to adoption. Put simply, there is no perfect replacement index out there.
Jeff notes that ultimately, it’s about finding the right tool for the job. And while you may have to “retire” one tool, we hope this Bulletin helps you discover the best alternative for the job at hand.
Vin Clevenger, Managing Director
There are several candidates ready to step in to fill the reference rate index void left by the “end of LIBOR.” In fact, many have been around for a long time. Fed Funds, Prime, and Treasury are all short-term rate indices that have derivatives contract traded on them. But the index that has been anointed the winner in the “large finance” space as a LIBOR replacement is the Secured Overnight Financing Rate (SOFR).
When I say “large finance,” I am referring to market participants like FNMA, FHLMC, and the FHLB. Logically, we are seeing increasing levels of derivatives trades and debt issuance using SOFR in recent times, often a result of these and other large finance companies becoming more active in phasing out LIBOR, and thus solidifying SOFR’s place as a key LIBOR replacement.
If this is the case, why are we still hearing so much about other indices that include some newcomers like Ameribor and the Bloomberg Short-Term Bank Yield (BSBY) indices? Time to dig in on the issues more deeply.
Secured vs. Unsecured Rates
One of the key points in the debate of how SOFR will perform vs. LIBOR is the fact that SOFR is a secured finance index, while LIBOR was not. Unlike Fed Funds that is set by and largely executed with the Federal Reserve, LIBOR was set by a number of non-government based independent institutions to identify a rate they would be willing to lend to each other (note: this originally was a good thing until some of them colluded and manipulated the LIBOR market…thus our discussion today).
The difference is that when market disruptions occur, the Fed often steps up to soothe and stabilize the market by pumping liquidity into the system and making it cheap.
LIBOR is based on bank-to-bank lending rates, which brings a credit component to the party that the Fed Funds rate lacks.
How can this make a difference that matters to a community-sized financial institution?
The best recent example of this was when Lehman Brothers collapsed. The Fed Funds Effective rate fell approximately 130bps from the mid-point of September 2008 to the midpoint of October 2008. One Month LIBOR increased by approximately 210bps in that same period. A commercial loan portfolio linked to one or the other may not make a difference “most of the time” (note: Fed Funds Effective and 1 Month LIBOR are 88% correlated going back to the beginning of the century), but my guess is that the 340bps delta between how the two moved would not have made a lot of sense if you were tied to Fed Funds at that point in time.
Similarly, the US Treasury rates tell us what the US Treasury can fund at. In a crisis where credit is not free-flowing and there is a flight to safety, the rate the US Treasury can finance at probably means about as much to you as the number of craters on the moon. That risk-free 3-month Treasury rate, by the way, is about 87% correlated to 3-month LIBOR since the year 2000.
With the above as background, how do we proceed?
If you have not already begun the process of working through fall back index language in your various financial contracts, you are behind in this sprint to June of 2023. The difference between 1 month LIBOR (10bps) and the Secured Overnight Financing Rate (SOFR, 1bps) may not mean that much to you, or maybe it does.
Determining that day one adjustment impact can be done on the back of the envelope in many cases, and that sets up the strategy discussion for minimizing the adverse impact that is more in your control.
In the cases where you can more readily influence the outcome, use the added time afforded by the deadline extension carefully. For example, work with borrowers well in advance to discuss the situation and how you propose to proceed with substitution to an index you choose in a given situation. Knowing that might involve legal opinions and education of staff and customers alike. Give yourself as much runway as you can to work through this and potential outlier issues.
On new contracts, phase out LIBOR sooner than later (if you have not done so already). The continued use of LIBOR was one of the pressure points the regulatory community “called out” recently, which has only elevated the LIBOR replacement discussion in many board conference rooms.
One should also work with vendors to determine if the LIBOR cessation will create operational disruptions. For instance: perhaps your loan pricing model keys off the LIBOR swap curve. Is shifting to a new rate structure curve a heavy lift? If not, what are the options, and do they align with your actual pricing philosophy on that particular part of your balance sheet?
The Right Tool for the Job
The truth is that no index is “perfect” for every application on your balance sheet. One index will be more applicable in a use case you have for lending, while another will be more applicable in hedging wholesale funding costs. The reality of the situation is your institution has already been in the practice of using a variety of rate indices, and that will not change. The only change is that LIBOR will not be one of them moving forward. How will this impact your business?
To Hedge or Not to Hedge
From my vantage point, it has been rare to see any index except for LIBOR used in the back-to-back swap business. Part of the reason is that LIBOR has been a much deeper hedge market, which enables BTB swap users to offer more competitive fixed rates to customers. Going forward, if the “street-facing swap” is most likely indexed to SOFR because the swap market is the most liquid, it is only logical that the “borrower facing swap” and loan contract is indexed to SOFR as well.
In recent times, we have seen wholesale funding cashflow hedges (locking in a fixed funding cost) executed using Fed Funds Effective more than LIBOR in anticipating LIBOR will cease to exist soon. But over time and as more of the cost of FHLB funding structure is more heavily influenced by SOFR that well might change, and Fed Funds swaps might not be a liquid or effective as they have been today.
In both cases, I am assuming that most “street-facing” derivatives will be with larger institutions and the best execution and lowest cost will be using the more liquid hedge index, which I am assuming will in fact be SOFR. Additionally, matching the variable rate index of the hedge to the financial instrument hedge results in tighter hedge correlation and thus easier to manage with fewer potential accounting surprises.
Thus if you are active or considering upping your use of derivatives in the future, SOFR is likely to be a key index in your operations. But what if you are less inclined to hedge?
Loan Rate Setting: a Prime Question
Wall Street Journal (WSJ) Prime has been considered the “fair short-term borrowing rate for a “big bank Prime flat credit.” The rate is set by a number of larger banks in the WSJ survey, is published/transparent, has a long history, and should have some correlation to wholesale funding rates that track reasonably tight to Fed Funds target (note: the spread of WSJ Prime to Fed Funds has been 3% for as long as I can remember).
Prime has many of the same attributes of LIBOR. So why did Prime lose popularity versus LIBOR to begin with?
Well, that part about Prime being pegged to 3% over the Fed Funds rate creates the same issues outlined earlier in getting paid a fair rate for extending credit in a more adverse environment. The derivatives market (particularly for options like interest rate caps and floors) for Prime is a lot thinner than other indices, which makes use of the Prime in managing loan-related interest rate risk more of a theoretical exercise than a functional one.
I am not suggesting Prime will go away as well as LIBOR. It remains widely used and easy to understand by many customers. But we should at least look for alternatives that are better matched to tasks at hand.
Time to Reassess the Index Lineup
Now is the time to ask what your goal is when evaluating the adoption of a new index. In loan pricing (and putting hedge accounting intricacies aside), is the goal to establish a reasonable rate over your cost of funds? As pointed out above: WSJ Prime, Treasury rates, and Fed Funds have a track record of failure in this area.
Accordingly, the use of FHLB advance rates has become more popular in benchmarking loan rates. The FHLB curve provides a real-world reference point for reliably match funding away the interest rate risk of similar term for a loan. One downfall of the FHLB is the rates in your district may vary noticeably from others, both on the short and long end of the rate curve.
This is part of why we see the recent rise of new reference rate indices such as the BSBY and Ameribor. With the latter, the American Financial Exchange (AFX) has created a bank-to-bank financial exchange that is reasonably large and geographically diverse across the United States. AFX observes those unsecured lending rates, posts the average, but does not set the underlying rates are willing to lend at. And as the platform and index have matured, it created a futures market that enables hedging activities.
While no index is perfect, many are looking at options like Ameribor as being more closely aligned to their lending than SOFR.
Sadly, the artist formerly known as Prince passed before he could pen an anthem timed to celebrate the end of the process of winding down the use of LIBOR. But in 1984, Don Henley released the triple-platinum album “Building the Perfect Beast.” In building mechanics, there is a phrase that almost everyone knows: “The right tool for the job.” You may be able to get the job done with something “close,” but you might not do the job as effectively unless you use the right tool best matched for that job.
Similarly, your banker’s toolbox has several rate indices you can use for different jobs on your balance sheet and in operations. Bankers have found the best fit for a given job may not be the same index as it is for another job. The only change that is happening as we near June of 2023… is that LIBOR will not be one of them.
One can only hope what many feel will be true: The LIBOR transition (for most and with some effort) will be a “non-event” similar to Y2K. But throughout this process, we feel it is wise to use the LIBOR cessation event as an opportunity to survey the tools available for different jobs to optimize efficiency going forward.
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ABOUT THE AUTHOR
Jeff Reynolds is a Managing Director at Darling Consulting Group. Jeff’s primary responsibility is advising clients on ways to enhance earnings while more effectively managing their risk positions. He regularly assists clients with strategic and capital planning projects and has also served on numerous due diligence teams for client acquisitions.
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