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.