How regional banks could shape US Libor replacement

A group of regional banks could have a big influence on benchmark rate reform in the US. In a letter to US regulators, the banks expressed concerns about the lack of credit sensitivity in the replacement benchmark of choice, the US secured overnight financing rate (SOFR). In response, regulators launched the Credit Sensitivity Group – to little fanfare – in February this year.

Leading representatives from the US Federal Reserve Board, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation convened the CSG with an “intent … to focus on the issues surrounding [the] credit-sensitive rate/spread that could be added to SOFR, but not to become an ‘alternative ARRC’ [Alternative Reference Rates Committee]”.¹

The CSG’s inaugural February meeting focused on the group’s primary objectives: to build a shared understanding of the challenges of US regional and community banks in shifting to SOFR; and to support resilience in times of stress.

In their 2019 letter to regulators, regional banks highlighted the potentially adverse impact on their ability to manage their balance sheets in times of economic stress that a move from US dollar Libor to a standalone SOFR could create. They argued that, during these times, the mismatch between SOFR and Libor would cause the return on banks’ SOFR-linked loans to decline as banks’ unhedged cost of funds increased.

SOFR differs economically from Libor. First, because it is an overnight rate and Libor is a term rate. Second, because it is secured by US Treasuries and Libor is unsecured. Libor also contains a dynamic, embedded interbank credit premium that moves in line with the markets’ perception of bank creditworthiness, while SOFR does not.

SOFR tends to track the risk-free rate or the effective federal funds rate, which is controlled by the US Federal Reserve. This means that, in times of financial stress, Libor edges higher as credit spreads in the market widen, and SOFR moves lower in concert with the official target rate, which is controlled by the Fed.

Some propose using the credit default swap market as a proxy, while others suggest using certain measures of volatility. But both of these could suffer from the same flaws as Libor

This was borne out during the market stress seen in March, as SOFR neared zero – tracking Fed funds – its spread to Libor moving higher.

Now for the hard part

Forming the group could prove to be the easy part of the mandate. There are significant challenges to calculating a robust, dynamic credit spread (DCS). The biggest question is how this rate can be calculated in a sustainable, compliant and easily understood way.

Some propose using the credit default swap market as a proxy, while others suggest using certain measures of volatility. But both of these could suffer from the same flaws as Libor, in that the underlying volume of transactions is unlikely to be sufficient to comply with International Organization of Securities Commissions principles.

This thin transaction volume, creating risk for the wider financial system, was the main rationale for the global transition away from Libor in the first place. So, reintroducing this type of risk would be counterintuitive.

And even with the definition of the supplemental rate/spread established, the CSG must still construct an implementation road map for the large and diverse US regional and community banking sector.

But with the US in the grip of a global pandemic, its businesses are rightly prioritising operational resilience and continuity over transformation initiatives such as Libor transition.

The UK’s Financial Conduct Authority, the Libor regulator, confirmed last month that the benchmark’s planned cessation at the end of 2021 has not changed, despite the impact of Covid-19. Just as the prospect of the economy gearing up again by June – at least, in part – appears more likely, the US financial system’s readiness for the end of Libor in 18 months’ time looks increasingly unlikely.

With less than 20 months until Libor becomes unavailable or unusable – and FCA acknowledgement that a degraded form of Libor should be avoided – the impact of Covid-19 probably increases the likelihood that consensus will be reached to identify a supplemental dynamic credit spread for SOFR.

It also could increase the chances that a DCS becomes more widely adopted than previously anticipated, as Covid-19 has offered a stark reminder that the Libor vs SOFR basis will widen in times of market stress.

Concerned market participants must have a plan in place to manage this.

Marcus Burnett is the director of SOFR Academy, and is based in New York. He is a former interest rate derivatives trader

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