As a follow up to my recent blog post, Banking Without LIBOR, I wanted to take a deeper look at the alternative indexes being offered to the widely utilized London Inter-Bank Offered Rate (LIBOR) index.
The key challenge for most banks appears to be selecting a replacement. With a handful of front runners being touted as the most likely replacements, let’s have a look at what they are and how they work:
SOFR ‒ In the U.S., Alternative Reference Rates Committee (ARRC) has selected the Secured Overnight Financing Rate (SOFR) as the LIBOR replacement. This index originated in the repurchase markets. Banks sell minimum credit risk securities, such as Treasuries, and buy them back the next day. To ensure repayment, these transactions are secured and the spread is the interest rate on the overnight loan. These transactions are reported to the Fed where the data is consolidated as a weighted average, which the Fed then publishes as SOFR.
Compounded SOFR ‒ There has been concern in the banking sector about SOFR as a daily published index being a bit too volatile for traditional credit markets. To address this, the Fed has started averaging SOFR over a period of time (30, 60, 90, and 180 days) thus creating Compounded SOFR, with two versions being discussed at this time. The first is forward looking or Compound SOFR in Advance. In this version, prices from future contracts that reference SOFR are used to estimate market-implied forward SOFR rates at a given point in time. They are then compounded to produce forward-looking term rates. The second version is Compounded SOFR in the Arrears. As the name implies, this looks at and averages the rate movement over a specified period of time in the arrears.
CIDOR or CORRA – Canadian markets have two potential alternative indexes emerging. Option one is Canada Three Month Interbank Rate (CIDOR), an interbank rate of interest charged on short-term loans made between banks. Option two is the Canadian Overnight Repo Rate Average (CORRA), a measure of the average cost of overnight collateralized funding in Canadian Dollars.
SONIA – Sterling Overnight Interbank Average Rate (SONIA) is a UK-based alternative index being offered by their regulating bodies. SONIA represents an unsecured overnight rate paid by banks for transactions in British Pound Sterling.
EOIA – A similar option is gaining ground in rest of Europe. Euro Overnight Index Average (EOIA) is being offered as a frontrunner replacement to LIBOR. This is the rate at which the banks in the EU and EFTA lend Euro-based funds in the interbank money market.
Prime ‒ Back in the U.S., we also have the long-standing U.S. Prime Rate. Every U.S. bank sets its own Prime Rate. At its core, the Prime Rate is tied to America's benchmark interest rate, the Federal Funds Target Rate (FFTR). Since 1994, a rule of thumb for the U.S. Prime Rate has been to add three percentage points to the FFTR.
CMT ‒ Constant Maturity Treasury Index (CMT) represents a weekly or monthly average yield for U.S. Treasuries. This is an established index that accurately reflects U.S. market conditions. Since Treasuries are considered risk-free, the lenders will typically add a risk premium to the rate.
AMERIBOR – This is a newer version of the U.S.-based Interbank Rate index utilized by regional banks. AMERIBOR is an interest rate benchmark that reflects the actual unsecured borrowing costs of over 1,000 American banks and financial institutions and contains a credit spread component based on unsecured loans. This index’s structure appears to be the closest to the key components found in LIBOR.
Banks should also be aware of additional considerations, such as tax implications, when thinking about the LIBOR transition. The IRS and the U.S. Treasury have started to address this by releasing the October 2019 Published Guidance. Some of the state bank governing bodies are also outlining their own transition requirements. New York State Department of Financial Services, for example, has just issued an extension for regulated banks in New York State to submit their LIBOR risk management plans by March 23, 2020 (DFS.NY.GOV Libor Update).
As we move toward the 2021 deadline, decisions must be made surrounding which index to adopt next. As you continue your discussions, keep in mind that the replacement index needs to be suitable to your current portfolio of loans, functionally fit within your servicing platform, maintain the stability and flexibility of LIBOR, and most importantly, be accepted by your customers.
If you need assistance at any stage of this transition, our Banking & Regulatory Solutions is available to assist.