In June 2017, the Alternative Reference Rates Committee (ARRC) selected the Secured Overnight Financing Rate (SOFR) as the replacement for USD LIBOR. SOFR is based on the overnight interest rate received for lending cash against Treasury securities. These debts are backed by the collateral of US Treasuries, making SOFR a secured rate. Futures and overnight index swaps, as well as some corporate debt, already use SOFR.
The Federal Reserve Bank of New York has been publishing the SOFR for over a year. But with the UK’s Financial Conduct Authority only committing to publish LIBOR through 2021, regulators say that too few institutions are making rates a priority.
At the beginning of the year we reported guidance for community banks. The guidance was to avoid writing new loans using LIBOR, to start tapering their reliance on that rate and smooth the transition to SOFR. This month, New York Fed President John Williams stated that LIBOR-reliant contracts “continue to be written”.
Why the hesitation on SOFR?
This is not to say that SOFR is a perfect, out-of-the-box replacement to LIBOR. As the New York Fed has acknowledged—as an overnight rate, SOFR has not yet established a forward-looking term reference rate. It is understandable that institutions are not jumping into SOFR with both feet just yet.
Of course, it’s important to remember that no-one should view, or approach, this transition as an immediate, overnight change. The expectation is that a term structure for SOFR will emerge over the same period that LIBOR continues to decline in reliability. Instead, banks should look to introduce fallbacks to LIBOR, and begin a slow shift away from the outgoing rate. In Williams’ words: “every new USD LIBOR contract written digs a deeper hole”.
So what should you do with reference rates?
While SOFR remains the preferred alternative to USD LIBOR according to the ARRC, each institution must determine the most appropriate reference rate—and timeline for transition—based on their own cost of funds, lending niche, loan pricing methodology, competitive landscape and more. But regardless of the outcome of that decision, banks need to be proactive. Any institution still writing contracts using LIBOR without a robust fallback is leaving itself open to grave uncertainty post-2021. The ARRC’s most recent guidance on fallback contract language reaffirms the need for back-up plans, and to take steps to lessen the institution’s exposure to LIBOR.
Your corporate partners including finance, controllers, and risk managers will be critical in assessing your options and getting the ball rolling. And the sooner you are in a position to communicate plans to investors, clients, and customers—the better.
If you’d like to discuss this topic with the Dashboard team, please contact us.