U.S. regulators encourage banks to cease entering new contracts that use LIBOR by the end of 2021. As this deadline draws closer, banks should continue to take necessary steps to prepare for the discontinuation of LIBOR.
The London Interbank Offered Rate (LIBOR) is widely used by banks as a standardized benchmark for setting the interest rates charged on adjustable rate loans. LIBOR is based on submissions provided by a panel of 20 banks. These submissions are intended to reflect the interest rate at which banks could borrow money on unsecured terms in the wholesale markets. Following the financial crisis, investigations revealed that multiple banks manipulated interbank lending rates downward for their benefit. As a result of this scandal, LIBOR has become a less reliable and credible benchmark.
Timeline of the LIBOR transition
In 2014 the Federal Reserve Board and the New York Fed jointly convened the Alternative Reference Rates Committee (AARC). This committee was formed to address risks related to LIBOR that were founded by the Financial Stability Board and the Financial Stability Oversight Council. The AARC’s initial objectives included identifying best practices for alternative reference rates, identifying best practices for contract robustness, developing an adoption plan, and creating an implementation plan with metrics of success and a timeline.
In 2017 the AARC identified the Secured Overnight Financing Rate (SOFR) as the replacement for LIBOR and introduced the Paced Transition Plan, which included steps and a timeline to adopt SOFR. The AARC was reconstituted in 2018 with an expanded membership to help ensure successful implementation of the committee’s plan and addressed increased risk that LIBOR may not exist beyond 2021. The U.K.’s Financial Conduct Authority (FCA) is responsible for regulating LIBOR. The FCA confirmed that 1-week and 2-month USD LIBOR will cease to be provided immediately after December 31, 2021, with the remaining UDS LIBOR panels ceasing after June 30, 2023.
What is SOFR?
The SOFR is a broad measure of the cost of borrowing cash overnight, collateralized by the U.S. Treasury securities in the repurchase agreement (repo) market. This rate has been published by the New York Fed each business day at 8 a.m. EST since April 2018. The volume is just short of $900 billion and the rate has remained at 5 basis points since October 26, 2021 (see chart below).
*Source: Federal Reserve Bank of New York
There are notable differences between LIBOR and SOFR that should be reviewed. Unlike LIBOR, SOFR is a more accurate representation to measure the cost to borrow money. SOFR reflects the retrospective actual cost of borrowing cash overnight. As shown in the chart above, SOFR is based on billions of dollars of daily transactions—actual data—whereas LIBOR has a limited number of transactions between banks, making it more judgment based. Additionally, LIBOR is an unsecured rate whereas SOFR is a secured rate with U.S. Treasuries as collateral. Therefore, LIBOR includes a credit risk premium and SOFR is a risk-free rate with little to no credit risk premium. Finally, since SOFR accounts for overnight transactions, it is based on one structure versus LIBOR which publishes multiple term structures. Being aware of these key differences will help you prepare for the transition.
Impact to interest rate risk model
UMB’s asset liability management (ALM) clients submit instrument-level data that are run through the model. The process for aggregating loan data includes providing margin and index values for adjustable/variable-rate loans. The system will calculate a margin value if an index value is provided. If the index field is left blank, the instrument is treated as a fixed-rate loan. We will work with you as your institution prices new loans or transitions existing loans tied to SOFR.
Our team has tools in place to accommodate the transition to alternative risk-free rates. SOFR has been implemented into the latest version of our model for 2022. The following updates were applied to add SOFR to the system curves:
- Single point yield curve that stores the overnight SOFR interest rate.
- An 11-point yield curve that stores the spread between SOFR and the OIS curve.
- Yield curve that stores the contract days and rate for SOFR futures contracts.
- SOFR Curve, a discount curve made up of six underlying structures.
- Indices that reference the SOFRRATE and uses the SOFR discount curve to generate forward rates (overnight, 30 days, 90 days, 180 days).
- Index Transition Matrix that allows for changing an instruments coupon index to a new index, an additional spread, and/or multiplier on a future date.
LIBOR transition imminent
Bank regulators have issued statements to encourage banks and credit unions to transition away from USD LIBOR. With deadlines in sight, modeling SOFR curves and indices will be necessary.
The UMB Capital Markets Division is here to assist your institution with this transition and incorporate SOFR in your ALM reports. If you would like to further discuss this topic, please contact your UMB investment officer or financial services group analyst.
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