AMERIBOR Benchmark Offers Options for Bank Capital Raises

Banks that belong to the American Financial Exchange (AFX) are not waiting until 2021 to make the switch away from the troubled London Interbank Offered Rate, or LIBOR, interest rate benchmark for pricing their offerings in the capital markets.

These institutions, which represent $3 trillion in assets and more than 20% of the U.S. banking sector, are using AMERIBOR® to price debt offerings now. They say AMERIBOR®, an unsecured benchmark, better reflects the cost of funds as represented by real transactions in a centralized, regulated and transparent marketplace. The benchmark has been used to price loans, deposits, futures and now debt — a critical step in a new benchmark’s development and financial innovation.

In October, New York-based Signature Bank announced the closing of $375 million aggregate principal amount of fixed-to-floating rate subordinated notes due in 2030 — the first use of AMERIBOR® in a debt deal. The notes will bear interest at 4% per annum, payable semi-annually. For the floating component, interest on the notes will accrue at three-month AMERIBOR® plus 389 basis points. The offering was handled by Keefe Bruyette & Woods and Piper Sandler. The transaction was finalized the first week of October 2020.

Signature Bank Chairman Scott Shay highlighted the $63 billion bank’s involvement as a “founder and supporter” of AFX.
“We are pleased to be the first institution to use AMERIBOR® on a debt issuance. … AMERIBOR is transparent, self-regulated and transaction-based, and we believe that it is already a suitable alternative as banks and other financial institutions transition away from LIBOR,” Shay said.

The inaugural incorporation of AMERIBOR® in a debt offering paves the way for more debt deals and other types of financial products linked to the benchmark. The issuance adds to the list of U.S. banks that have already pegged new loans to the rate, including Birmingham, Alabama-based ServicFirst Bancshares, Boston-based Brookline Bancorp and San Antonio-based Cullen/Frost Bankers. As AFX adds to deposits, loans and fixed income linked to AMERIBOR, the next risk transfer instrument up for issuance will be a swap deal.

Banks of all sizes have options to choose from when it comes to an interest rate benchmark best suited to their specific requirements. AMERIBOR® was developed for member banks and others that borrow and lend on an unsecured basis. Currently, AFX membership across the U.S. includes 162 banks, 1,000 correspondent banks and 43 non-banks, including insurance companies, broker-dealers, private equity firms, hedge funds, futures commission merchants and asset managers.

This article does not constitute an offer to sell or a solicitation of an offer to buy the notes, nor shall there be any offer, solicitation or sale of any notes in any jurisdiction in which such offer, solicitation or sale would be unlawful.

Recommendations for Banks Prepping for LIBOR Transitions, Updated Timelines

While much of the focus this summer was on Covid-19, the decline in GDP and the fluctuating UE rates, some pockets of the market kept a different acronym in the mix of hot topics.

Regulators, advisors and trade groups have made significant movement and provided guidance to help banks prepare for the eventual exit of the London Interbank Offered Rate, commonly abbreviated to LIBOR, at the end of 2021. These new updates include best practice recommendations, updated fallback language for loans and key dates to no longer offer new originations in LIBOR.

Why does this matter to community banks? Syndicated loans make up only 1.7% of the nearly $200 trillion debt market that is tied to LIBOR — a figure that includes derivatives, loan, securities and mortgages. Many community banks hold syndicated loans on their balance sheets, which means they’re directly affected by efforts to replace LIBOR with a new reference rate.

A quick history refresher: In 2014, U.S. federal bank regulators convened the Alternative Rates Reference Committee (ARRC) in response to LIBOR manipulation by the reporting banks during the financial crisis. A wide range of firms, market participants and consumer advocacy groups — totaling about 1,500 individuals — participate in the ARRC’s working groups, according to the New York Federal Reserve. The ARRC designated the Secured Overnight Financing Rate (SOFR) as a replacement rate to LIBOR and has been instrumental in providing workpapers and guidelines on SOFR’s implementation.

In April 2019, the ARRC released proposed fallback language that firms could incorporate into syndicated loan credit agreements during initial origination, or by way of amendment before the cessation of LIBOR occurs. The two methods they recommended were the “hardwired approach” and the “amendment approach.” After a year, the amendment approach was used almost exclusively by the market.

In June 2020, the ARRC released refreshed Hardwired Fallbacks language for syndicated loans. The updates include language that when LIBOR ceases or is declared unrepresentative, the-LIBOR based loan will “fall back” to a variation of SOFR plus a “spread adjustment” meant to minimize the difference between LIBOR and SOFR. This is what all other markets are doing and reduces the need for thousands of amendments shortly after LIBOR cessation.

In addition, the ARRC stated that as of Sept. 30, lenders should start using hardwired fallbacks in new loans and refinancings. As of June 30, 2021, lenders should not originate any more loans that use LIBOR as an index rate.

As the market continues to prepare for LIBOR’s eventual exit, BancAlliance recommends banks take several steps to prepare for this transition:

  • Follow the ARRC’s recommendations for identifying your bank’s LIBOR-based contracts and be aware of the fallback language that currently exists in each credit agreement. Most syndicated loans already have fallback language in existing credit agreements, but the key distinction is the extent of input the lenders have with respect to the new rate.
  • Keep up-to-date with new pronouncements and maintain a file of relevant updates, as a way to demonstrate your understanding of the evolving environment to auditors and regulators.
  • Have patience. The new SOFR-based credit agreements are not expected until summer 2021 at the earliest, and there is always a chance that the phase-out of LIBOR could be extended.

A Banker’s Perspective on LIBOR Transition to SOFR

The scandal associated with manipulation of the London Interbank Offered Rate (LIBOR) during the 2008 financial crisis caused a great deal of concern among banking and accounting regulators. In 2014, the Financial Stability Oversight Council recommended that U.S. regulators identify an alternative benchmark rate to LIBOR.  This recommendation was given an effective timeline in 2017 when the UK Financial Conduct Authority, as the regulator of LIBOR, announced the intent to discontinue the rate by year-end 2021. The Federal Reserve and the Alternative Reference Rates Committee (AARC) have since recommended the Secured Overnight Funding Rate (SOFR) as the recommended replacement rate for LIBOR.  Additionally, the AARC recommends that all LIBOR loan agreements cease using any LIBOR index rates by Sept. 30, 2021.

The transition to SOFR presents two distinct challenges for U.S. banks: term structure and fallback language.

Term structure: SOFR is an overnight rate, and not directly appropriate for term lending with monthly or quarterly resets. As such, several possibilities for using SOFR for term lending have emerged, with the main recommendation being Daily Simple SOFR plus a spread adjustment.  This spread adjustment is currently 12 basis points for 1-month LIBOR and 26 basis points for 3-month LIBOR, reflecting the difference between SOFR as a secured rate and LIBOR as an unsecured rate.  More importantly, Daily Simple SOFR is an arrears calculation, which is not particularly client-friendly for a standard commercial bank loan. Nevertheless, the AARC recommends that Daily Simple SOFR be used to replace LIBOR until a true term SOFR rate emerges.

SOFR vs 1-month LIBOR

Source: Federal Reserve Bank of New York

Banks are continuing to discuss options that would be easier for clients to understand on smaller bilateral loans, including prime or a historical average SOFR set at the beginning of an interest period (Figure 1). While not necessarily in-line with the cost-of-funds approximation of Daily Simple SOFR in arrears, the ability to set a rate at the beginning of an accrual period may be more appealing for client-friendly relationship banking.  Overall, the market still needs to settle on the best SOFR rate solutions for bilateral bank loans, and banks need to have a plan for using overnight SOFR until a true term SOFR rate is available.

Figure 1: Calculation Options for monthly payment

Fallback language: Most existing loan documentation is not expected to support SOFR without amendment. The AARC recommends adding “fallback language” to existing loan documents, with a very specific “hardwired” approach to using SOFR. This language defines a “waterfall” of options, depending upon what SOFR rates are available. However, many banks have also been working through a more general fallback language, to allow greater flexibility for different types of SOFR calculations as well as the use of other replacement rates. Whatever language is used, however, commercial banks are likely to have hundreds of thousands of floating-rate LIBOR loans that will need to be amended with new fallback language within the next 10 months.

In light of these issues, banks need to examine three key areas that will be affected by LIBOR replacement: documentation, systems and analytics.

Documentation: All existing LIBOR-based loans will need to be reviewed and potentially amended with appropriate fallback language before September 2021.  Amendments will require consent and signature from clients, opening the opportunity for negotiation of existing terms. Banks should have appropriate legal and banker teams working the review and amendment negotiation process with clients. And plenty of time should be allocated for these amendments to be executed and booked ahead of the fourth-quarter 2021 discontinuation of LIBOR.

Systems: All loan and trading systems that index to LIBOR will need to be re-coded to support SOFR. Most major loan system vendors have already created updates to support multiple SOFR calculations, which banks will need to install and test before re-booking amended LIBOR loans. Interfaces and downstream systems may also be impacted. Overall, a full enterprise examination of systems is required as loan systems are re-coded for the SOFR rate.

Analytics: All models — including those used for funds transfer pricing, risk adjusted return on capital and asset-liability management — will need to be rebuilt and pushed into production to support a new SOFR base rate.  Aligning the new floating rate index of SOFR with the models used internally to price funds and risk is essential to ensure that lending is evaluated appropriately.

The move from LIBOR to SOFR is now less than a year away. Bankers have generally embraced an approach to using SOFR; however, there is a great deal of work to be done on documentation, systems and models to be ready for the conversion in 2021.

When Rates are Zero, Derivatives Make Every Basis Point Count

It’s been one quarter after another of surprises from the Federal Reserve Board.

After shocking many forecasters in 2019 by making three quarter-point cuts to its benchmark interest rate target, the data-dependent Fed was widely thought to be on hold entering 2020. But the quick onset of the coronavirus pandemic hitting the United States in March 2020 quickly rendered banks’ forecasts for stable rates useless. The Fed has acted aggressively to provide liquidity, sending its benchmark back to the zero-bound range, where rates last languished from 2008 to 2015.

During those seven years of zero percent interest rates, banks learned two important lessons:

  1. The impact of a single basis point change in the yield of an asset or the rate paid on a funding instrument is more material when starting from a lower base. In times like these, it pays to be vigilant when considering available choices in loans and investments on the asset side of the balance sheet, and in deposits and borrowings on liability side.
  2. Even when we think we know what is going to happen next, we really don’t know. There was an annual chorus in the early and mid-2010s: “This is the year for higher rates.” Everyone believed that the next move would certainly be higher than the last one. In reality, short-rates remained frozen near zero for years, while multiple rounds of quantitative easing from the Fed pushed long-rates lower and the yield curve flatter before “lift off” finally began in 2015.

The most effective tools to capture every basis point and trade uncertainty for certainty are interest rate derivatives. Liquidity and funding questions have taken center stage, given the uncertainty around loan originations, payment deferrals and deposit flows. In the current environment, banks with access to traditional swaps, caps and floors can separate decisions about rate protection from decisions about  funding/liquidity and realize meaningful savings in the process.

To illustrate: A bank looking to access the wholesale funding market might typically start with fixed-rate advances from their Federal Home Loan Bank. These instruments are essentially a bundled product consisting of liquidity and interest rate protection benefits; the cost of each component is rolled into the quoted advance rate. By choosing to access short-term funding instead, a bank can then execute an interest rate swap or cap to hedge the re-pricing risk that occurs each time the funding rolls over. Separating funding from rate protection enables the bank to save the liquidity premium built into the fixed-rate advance.

Some potential benefits of utilizing derivatives in the funding process include:

  • Using a swap can save an estimated 25 to 75 basis points compared to the like-term fixed-rate advance.
  • In early April 2020, certain swap strategies tied to 3-month LIBOR enabled banks to access negative net funding costs for the first reset period of the hedge.
  • Swaps have a symmetric prepayment characteristic built-in; standard fixed-rate advances include a one-way penalty if rates are lower.
  • In addition to LIBOR, swaps can be executed using the effective Fed Funds rate in tandem with an overnight borrowing position.
  • Interest rate caps can be used to enjoy current low borrowing rates for as long as they last, while offering the comfort of an upper limit in the cap strike.

Many community banks that want to compete for fixed-rate loans with terms of 10 years or more but view derivatives as too complex have opted to engage in indirect/third-party swap programs. These programs place their borrowers into a derivative, while remaining “derivative-free” themselves. In addition to leaving significant revenue on the table, those taking this “toe-in-the-water” approach miss out on the opportunity to utilize derivatives to reduce funding costs. 

While accounting concerns are the No. 1 reason cited by community banks for avoiding traditional interest rate derivatives, recent changes from the Financial Accounting Standards Board have completely overhauled this narrative. For banks that have steered clear of swaps — thinking they are too risky or not worth the effort — an education session that identifies the actual risks while providing solutions to manage and minimize those risks can help a board and management team separate facts from fears and make the best decision for their institution.

With the recent return to rock-bottom interest rates, maintaining a laser focus on funding costs is more critical than ever. A financial institution with hedging capabilities installed in the risk management toolkit is better equipped to protect its net interest margin and make every basis point count.

The Year Ahead in Banking Regulation

Although it is difficult to predict whether Congress or the federal banking agencies would be willing to address in a meaningful way any banking issues in an election year, the following are some of the areas to watch for in 2020.

Community Reinvestment Act. The Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. issued a proposed rule in December 2019 to revise and modernize the Community Reinvestment Act. The rule would change what qualifies for CRA credit, what areas count for CRA purposes, how to measure CRA activity and how to report CRA data. While the analysis of the practical impact on stakeholders is ongoing and could require consideration of facts and circumstances of individual institutions, the proposed rule may warrant particular attention from two groups of stakeholders as it becomes finalized: small banks and de novo applicants.

First, for national and state nonmember banks under $500 million, the proposed rule offers the option of staying with the current CRA regime or opting into the new one. The Federal Reserve Board did not join the OCC and the FDIC in the proposed rule, so CRA changes would not affect state member banks as proposed. As small banks weigh the costs and benefits of opting in, the calculus may be further complicated by political factors beyond the four corners of the rule itself.

Second, a number of changes in the proposed rule could impact deposit insurance applicants seeking de novo bank or ILC charters, including those related to assessment areas and strategic plans.

Brokered Deposits. The FDIC issued a proposed rule in December 2019 to revise brokered deposits regulations. While the proposed rule does not represent a wholesale revamp of the regulatory framework for brokered deposits — which would likely require statutory changes — some of the changes could expand the primary purpose exception in the definition of deposit broker and establish an administrative process for obtaining FDIC determination that the primary purpose exception applies in a particular case. Also, the new administrative process could offer clarity to banks that are unsure about whether to classify certain deposits as brokered.

LIBOR Transition. The London Interbank Offered Rate, a reference rate used throughout the financial system that proved vulnerable to manipulation, may no longer be available after 2021. The U.K.’s Financial Conduct Authority announced in 2017 its intention to no longer compel panel banks to contribute to the determination of LIBOR beyond 2021. In the U.S., the Financial Stability Oversight Council has flagged LIBOR as an issue in its annual Congressional report every year since 2012. Its members stepped up their rhetoric in 2019 to pressure the financial services industry to prepare for transition away from LIBOR to a new reference rate, one of which is the Secured Overnight Financing Rate, or SOFR, that was selected by the Alternative Reference Rates Committee.

For banks in 2020, it is likely that federal bank examiners, whose agency heads are all members of the FSOC, will increasingly incorporate LIBOR preparedness into exams if they have not done so already. In addition, regulators in New York are requiring submission of LIBOR transition plans by March 23, 2020.

The scope of work to effectuate a smooth transition could be significant, depending on the size and complexity of an institution. It ranges from an accurate inventory of all contracts that reference LIBOR to devising a plan and adopting fallback language for different types of obligations (such as bilateral loans, syndicated loans, floating rate notes, derivatives and retail products), not to mention developing strategies to mitigate litigation risk. Despite some concerns about the suitability of SOFR as a LIBOR replacement, including a possible need for a credit spread adjustment as well as developing a term SOFR, which is in progress, LIBOR transition will be an area of regulatory focus in 2020.

LIBOR Changes On the Horizon for Syndicated Loans on Bank Books

LIBOR-9-2-19.pngAlthough the shift from LIBOR to a new reference rate is several years away, banks should start preparing today.

Syndicated loans make up only 1.7% of the nearly $200 trillion debt market that is tied to the London Interbank Offered Rate (LIBOR), a figure that includes derivatives, loan, securities and mortgages. But many banks hold syndicated loans on their balance sheets, and will be directly affected by efforts to replace LIBOR with a new reference rate.

In 2014, federal bank regulators convened the Alternative Rates Reference Committee (ARRC) in response to the manipulation of LIBOR by banks during the financial crisis. In 2017, the ARRC identified the Secured Overnight Financing Rate (SOFR) as the rate that represents best practice to replace LIBOR in USD derivative and other financial contracts.

Shifting from LIBOR to SOFR requires various moving pieces to converge as well as addressing legacy issues for existing contracts tied to LIBOR. The ARRC was reconstituted in 2018 with an expanded membership that includes regulators, trade associations, exchanges and other intermediaries, and buy side and sell side market participants. The group now oversees the implementation of the Paced Transition Plan and coordinates with cash and derivatives markets as they address the risk that LIBOR may not exist beyond 2021. This includes minimizing the potential disruption associated with LIBOR’s potential phase-out and supporting a voluntary transition away from LIBOR.

In April 2019, the ARRC released proposed fallback language that firms could incorporate into syndicated loan credit agreements during initial origination, or by way of amendment before the cessation of LIBOR occurs.

Contracts need recommended fallback language to provide consistency across products and institutions. The definition of LIBOR, the trigger events that would require use of the fallbacks and the fallbacks themselves vary significantly — even within the same product sets. Additionally, existing contractual fallback language was originally intended to address a temporary unavailability of LIBOR, like a glitch affecting the designated screen page or a temporary market disruption, not its permanent discontinuation. Until recently, fallback language rarely addressed the possibility of the permanent discontinuance of LIBOR. As a result, legacy fallback language could result in unintended economic consequences or potential litigation.

The ARRC recommends contracts have two sets of fallback language for new originations of U.S. dollar-denominated syndicated loans that reference LIBOR. Syndicated loan fallback provisions try to balance several goals of the ARRC: flexibility and clarity.

  1. Hardwired Approach:” This approach uses clear and observable triggers and successor rates with spread adjustments that are subject to some flexibility to fall back to an amendment if the designated successor rates and adjustments are not available at the time a trigger event becomes effective.
  2. Amendment Approach:” This approach is meant to offer standard language, which provides specificity with respect to the fallback trigger events and explicitly includes an adjustment to be applied to the successor rate, if necessary, to make the successor rate more comparable to LIBOR. It also includes an objection right for “Required Lenders.” In the Amendment Approach language, all decisions about the successor rate and adjustment will be made in the future.

As the market continues to prepare for LIBOR’s eventual exit, there are several steps that BancAlliance recommends that banks take to prepare for this transition:

  1. Quantify, document and monitor exposure to loans in your portfolio with LIBOR-based pricing.
  2. Ensure that executives are familiar with the current LIBOR fallback language in the individual credit agreements within the portfolio.
  3. Be mindful should any amendments occur to your existing portfolio, as SOFR’s acceptance grows in the marketplace.
  4. Continue observing new originations to see how fallback language is being drafted, and any other structural changes with regards to LIBOR.
  5. Review ARRC pronouncements and market-related current events to ensure your institution is up to speed on the latest news and changes with respect to LIBOR.

Farewell to LIBOR


LIBOR-11-20-17.pngFive years ago, a small bank that almost no one had ever heard of launched an epic battle against three of the largest financial institutions in the world for their role in facilitating a crisis that began more than a thousand miles away. In 2012, Community Bank & Trust, of Sheboygan, WI, filed a class action suit against Bank of America Corp., Citigroup and JPMorgan Chase & Co. for their part in the manipulation of the London Interbank Offered Rate, or LIBOR—the benchmark rate for tens of thousands of financial contracts including commercial loans, home loans, student debt, mortgages and municipal debt. The lawsuit claimed that small financial institutions like Community Bank & Trust lost $300 million to $500 million a year due to LIBOR rigging, and that big banks were part of an ongoing criminal enterprise and guilty of violating the Racketeer Influenced and Corrupt Organizations (RICO) Act.

LIBOR is the average rate at which a group of large, global banks—including Bank of America, JPMorgan and Citi—estimate they’d be able to borrow funds from each other in five different currencies across seven time periods, submitted by a panel of lenders every morning. U.S. banks began their gradual transition to the metric in the 1990s because, unlike the Prime Rate that was widely used prior to that period, LIBOR changes daily and is—in theory—tagged to market conditions.

LIBOR has been called the “most important number in the world,” and even though most community banks rely on Prime and constant maturity treasuries for interest rate indices to set loan or deposit rates, LIBOR is still a critical index for community banks. In the case of smaller commercial lenders, even minor fluctuations in the LIBOR rate can have significant consequences. By manipulating the floating rate, large banks with greater borrowing power and cash reserves can artificially suppress the index, squeezing returns for smaller institutions.

“The defendant banks, sophisticated investors who understand that LIBOR is a key metric, knew that manipulating [the rate] downward would directly and proximately harm the small community banks in which the defendants compete for loan business by artificially depressing the interest rate paid to community banks on loans held by those banks,” the complaint asserted.

That litigation is still playing out in a federal appeals court in New York. Meanwhile, financial institutions around the world have shelled out more than $9 billion in fines and settlements since then to settle litigation related to the LIBOR scandal, and several bankers have faced criminal convictions. But LIBOR is now on its way out. On July 27, 2017, Andrew Bailey, chief executive of the U.K. Financial Conduct Authority, announced that LIBOR will officially be replaced as the key index for overnight loans. As a result, lenders will transition to alternative rates over the next four years.

This summer the Federal Reserve’s Alternative Reference Rates Committee (ARRC) identified a broad treasuries repo financing rate as its U.S. dollar-preferred LIBOR alternative. The new metric will be called the Secured Overnight Financing Rate (SOFR), and will include tri-party repo data from The Bank of New York Mellon Corp., and cleared bilateral and General Collateral Finance Repo data from The Depository Trust & Clearing Corp. (A repo transaction is the sale of a security or a portfolio of securities, combined with an agreement to repurchase the security or portfolio on a specified future date at a pre-arranged price).

While protocols for making the transition have not yet been finalized, it’s not too early to begin preparing. According to the Loan Syndications and Trading Association, while most credit agreements already include customary fallback language if there is a temporary disruption to LIBOR, it would be prudent for parties to review their existing credit agreements to understand those provisions and what, if any, amendment flexibility exists to address a discontinuation of LIBOR. And as new agreements are drafted, parties may want to consider the ability to amend the agreement with less than a 100 percent lender vote to avoid market disruption in the event that LIBOR is permanently discontinued.

To make informed decisions, it behooves all community banks, even those that do not directly use LIBOR, to consider how the replacement metrics may impact their own interest rates.