Revisiting Funds Transfer Pricing Post-LIBOR

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The end of 2021 also brought with it the planned discontinuation of the London Interbank Offered Rate, or LIBOR, the long-running and globally popular benchmark rate.

Banks in a post-LIBOR world that have been using the LIBOR/interest rate swap curve as the basis for their funds transfer pricing (FTP) will have to replace the benchmark as it is phases out. This also may be a good time for banks using other indices, like FHLB advances and brokered deposits, and evaluate the effectiveness of their methodologies for serving their intended purpose. In both situations, newly available interest rate index curves can contribute to a better option for FTP.

The interest rate curve derived from the LIBOR/swap curve is the interest rate component of FTP at most large banks. It usually is combined with a liquidity transfer price curve to form a composite FTP curve. Mid-sized and smaller banks often use the FHLB advance curve, which is sometimes combined with brokered deposit rates to produce their composite FTP curve. These alternative approaches for calculating FTP do not result in identical curves. As such, having different FTP curves among banks has clear go-to-market implications.

Most large banks are adopting SOFR (secured overnight funding rate) as their replacement benchmark rate for LIBOR to use when indexing floating rate loans and for hedging. SOFR is based on actual borrowing transactions secured by Treasury securities. It is reflective of a risk-free rate and not bank cost of funds, so financial institutions must add a compensating spread to SOFR to align with LIBOR.

Many mid-tier banks are gravitating to Ameribor and the Bloomberg short-term bank yield (BSBY) index, which provide rates based on an aggregation of unsecured bank funding transactions. These indices create a combined interest sensitivity and liquidity interest rate curve; the interest rate and liquidity implications cannot be decomposed for, say, differentiating a 3-month loan from a 5-year loan that reprices every three months.

An effective FTP measure must at least:

  • Accurately reflect the interest rate environment.
  • Appropriately reflect a bank’s market cost of funding in varying economic markets.
  • Be able to separate interest rate and liquidity components for floating rate and indeterminant maturity instruments.

These three principles alone set a high bar for a replacement rate for LIBOR and for how it is applied. They also highlight the challenges of using a single index for both interest rate and liquidity FTP. None of the new indices — SOFR, Ameribor or BSBY — meets these basic FTP principles by themselves; neither can FHLB advances or brokered deposits.

How should a bank proceed? If we take a building block approach to this problem, then we want to consider what the potential building blocks are that can contribute to meeting these principles.

SOFR is intended to accurately reflect the interest rate environment, and using Treasury-secured transactions seems to meet that objective. The addition of a fixed risk-neutral premium to SOFR provides an interest rate index like the LIBOR/swap curve.

Conversely, FHLB advances and brokered deposits are composite curves that represent bank collateralized or insured wholesale funding costs. They capture composite interest sensitivity and liquidity but lack any form of credit risk for term funding. This works fine under some conditions, but may put these banks at a pricing disadvantage for gathering core deposits relative to banks that value liquidity more highly.

Both Ameribor and BSBY are designed to provide a term structure of bank credit sensitive interest rates representative of bank unsecured financing costs. Effectively, these indices provide a composite FTP curve capturing interest sensitivity, liquidity and credit sensitivity. However, because they are composite indices, interest sensitivity and liquidity cannot be decomposed and measured separately. Floating rate and indeterminant-maturity transactions will be difficult to correctly value, since term structure and interest sensitivity are independent.

Using some of these elements as building blocks, a fully-specified FTP curve that separately captures interest sensitivity, liquidity and credit sensitivity can be built which meets the three criteria set above. As shown in the graphic, banks can create a robust FTP curve by combining SOFR, a risk-neutral premium and Ameribor or BSBY. An FTP measure generated from these elements sends appropriate signals on valuation, pricing and performance in all interest rate and economic environments.

The phasing out of LIBOR and the introduction of alternative indices for FTP is forcing banks to review the fundamental components of FTP. As described, banks are not using one approach to calculate FTP; the results of these different approaches have significant go-to-market implications that need to be evaluated at the most senior levels of management.

Recommendations for Banks Prepping for LIBOR Transitions, Updated Timelines

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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

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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.