Tope Adedara, Internal Audit Director, ALM – Balance Sheet Management, PNC

Below is an insight into what can be expected from Tope’s session at Balance Sheet Management USA 2023.

The views and opinions expressed in this article are those of the thought leader as an individual, and are not attributed to CeFPro or any particular organization.

What are the potential issues that can arise after the swap from Libor? How are these best handled?

There could be several prongs to the potential issues arising from the LIBOR Transition. A few of those are:

• Making necessary changes to financial reports and closing gaps post-transition to enable seamless customer experiences.
• Challenges interpreting the LIBOR Replacement Index, determining new rates, and implementing the new reference rates across pay-offs, pay-ins, cash flows, etc.
• IT systems integration challenges to accommodate reference rates input from external systems.
• Trailing legacy book amendments, especially for situations where it is most efficient to transition loans in accordance with reset dates.
• Insufficient fallbacks, loans without a clear path to a new rate; what are the available options (Synthetic LIBOR, Board Rate, Base Rate plus)?
• The strength of the Adjustable Interest Rate (LIBOR) Act of 2021 (enacted in the United States) if unwilling customers challenge banks.
• Slower progress in the syndicated loans market.

While different issues will attract different solutions, the overarching goal for financial institutions must be to ensure that all existing agreements are successfully transitioned; they should monitor any further changes and, identify lingering exposures/assess the impact on operations post-transition.

What are the main risks in a post-LIBOR world?

In a post-LIBOR world, firms could still face legal, operational, credit, conflict of interest, conduct, and reputational risks.

• Legal and operational risks:For US banks, highly complex LIBOR-linked contracts issued overseas and not subject to the Adjustable Interest Rate (LIBOR) Act of 2021 and instances where no fallback language exists and/or transition through an amendment pathway may not be practical.
• Credit risk:The transition to the Secured Overnight Funding Rate (SOFR) has been well-documented in the past years, and US banks are mostly prepared for this new rate regime. About 95% of US loans are tied to SOFR. Interestingly, LIBOR’s demise comes on the heels of the destabilizing outflow of deposits at the US mid-tier banks. The challenge with SOFR, though, is the absence of a credit component. Banks will have to figure out how to manage credit components through SOFR, considering the pressure on the fund costs, especially with the current hyperinflated environment and historically unparalleled high-interest rates.
• Conflict of interest, conduct, and reputational risks:These risks are intrinsically linked and must be balanced alongside the firm’s financial risks. As part of their fiduciary duty, firms should continue to consider how these risks are related to post-transition, including, for example, cross-trading, principal transactions, allocation of post-transition costs, and clients with conflicting priorities.

Why is managing the credit component of interest rate risk important?

A significant function of a financial institution is to effectively identify, measure, monitor, and control interest rate risk exposure through effective policies and risk management processes. If not properly managed, the bank’s current or future earnings and capital will be exposed to changes (beneficial or adverse) in market rates.

The events of the past 6-8 months in the US banking system with three bank failures, due to inadequate interest rate risk management and other factors present the need for sound risk management, not just on interest rates but all other risks that may affect the safety and soundness of a bank.

Post-LIBOR, countries, and regions are identifying new rates for future transactions. In the US, the post-LIBOR rate will be Secured Overnight Funding Rate (SOFR – this is based on treasury repo transactions, which are fully secured by the most liquid, creditworthy collateral, and they are generally overnight loans), in Japan, the new rate is Tokyo Over-Night Average Rate (TONAR), United Kingdom has transitioned to Sterling Overnight Index Average (SONIA), Europe has transitioned from European Overnight Index Average (EONIA) to Euro Short Term Rate (€STR or ESTER), and Switzerland has transitioned to Swiss Average Rate Overnight (SARON); all of these rates are “risk free rate” (RFR).

On the contrary, banks do not fund themselves at the risk-free rate for unsecured financings. Therefore, a lender that makes a loan on an unsecured basis must account for the risk (however small) that the borrower will default during the loan and the lender will not recover the total amount of its loan.

The importance of the credit component is not debatable; the fundamental question will be in the post-LIBOR world of RFRs: how do banks bake in credit sensitivity spread to account for their lending risks and current high-interest rate, especially in an environment that has been triggered by rate increases in the attempt of Federal Reserve Banks to slow down the economy and curb the current high rates of inflation.

Currently, in the US, Adjustable-rate retail mortgage originations and almost all floating-rate debt issuance are based on SOFR, and SOFR represents more than 90 percent of risk traded in new derivatives activity. Although SOFR just began publication in 2018, more than $60 trillion of SOFR derivatives and $4 trillion in SOFR loans and debt instruments are outstanding.

Globally, the first attempt is to extend the overnight RFRs to accommodate forward-looking benchmarks. While most new derivatives, floating-rate debt, and consumer products reference RFRs or averages of RFRs directly, most new lending activity has moved to term RFR rates.

For example, the US has introduced “Term SOFR,” a daily set of benchmark forward-looking interest rate estimates calculated and published for 1-month, 3-month, 6-month, and 12-month tenors. Although credit adjustments are included in these term rates, it fails to account for the individual probability of default that banks typically have as part of their underwriting process.

As a result, each bank will have to explore ways to price its products to attach appropriate economic value to financial transactions.

How can institutions best manage funding costs when there is no way to hedge? Can you provide any examples?

LIBOR transition will impact not only the loan market but also derivatives and hedges. Typically, institutions will manage their cost of funds by securing an appropriate hedge; this is even more pertinent in a high-interest-rate environment.

As part of the LIBOR Transition, there is a provision that LIBOR-indexed interest rate hedges (including caps and swaps), which were outstanding on June 30, automatically converted to the International Swaps and Derivatives Association (ISDA) fallback rate. For hedges of one-month LIBOR, this fallback rate will be SOFR Compounded in Arrears plus an 11.448 basis point credit spread. The exception to this is interest rate caps on Agency loans (where the underlying loan was a Fannie Mae or Freddie Mac loan).

With LIBOR, hedging transactions are still available; however, the challenge with pricing makes it difficult for institutions to hedge properly.

In the first half of 2023, US-reported Over the Counter (OTC) Interest Rate Derivatives (IRD) traded notional referencing RFRs increased by 49.1% to $89.5 trillion in the first half of 2023 compared to $60.1 trillion in the second half of 2022. RFR transactions accounted for 48.5% of total OTC IRD traded notional in the first half of 2023, up from 43.5% in the second half of 2022.

Institutions can still manage their cost of funds by hedging, although it is more challenging considering the current reference rate environment, coupled with high-interest rates due to hyperinflated world economies.

How have institutions been impacted by the transition from Libor to the new SOFR?

In the United States, most corporate, commercial, and industrial (CC&I) lending takes the form of revolving lines of credit, known as revolvers or credit lines. For decades, revolvers of credit lines were typically indexed to the London Interbank Offered Rate (LIBOR). However, since 2022, the US and other developed-market economies have transitioned from credit-sensitive reference rates such as LIBOR to new risk-free rates such as the Secured Overnight Financing Rate (SOFR).

With this transition, coupled with the ongoing financial market crisis and the hyper-inflated global economies, the ability of banks to provide revolvers or credit lines, given the liquidity constraints and the high-interest rates environment, continues to be a challenge. While the overall impact cannot be fully determined, it is expected that corporations are already experiencing some challenges. Additional factors driving these dynamics are:

1. Relationship between revolving credit and bank funding risk – Credit lines allow companies to borrow funds at a pre-agreed fixed spread over a floating reference rate. When borrowers draw on their lines, banks must source the required cash—sometimes by borrowing in wholesale funding markets. Because credit line drawdowns tend to be larger when funding markets are stressed, the provision of revolving credit is associated with a funding risk.
2. Credit Supply as a function of Risk-Free or Credit Sensitive Rates – Linking revolvers to credit-sensitive rates like LIBOR serves as a disincentive to borrowers from drawing on their credit lines, especially when banks’ funding costs are high, and invariably the credit cost also high. In a post-LIBOR world of risk-free rates and the inability to effectively input credit spreads on funding costs, such an in-balance increases the incentive for borrowers to draw on their lines. Thus, the transition to risk-free reference rates increases the covariance between line draws and bank funding spreads. This could raise the cost to bank shareholders of offering revolvers.
3. Deposit Contraction and Costs – the volume of available deposits and the cost of such deposits directly correlate to the banks’ ability to offer and even extend revolver or credit lines. Within the US financial systems, the volume of deposits has reduced by about 5.5% from $18 trillion as of July 2022 to about $17.3 trillion as of July 2023; in the same period, deposit rates for 60 months CD for the same period has increased by about 60.6% from July 2022 (1.32%) to July 2023 (2.12%).

The challenges noticed are not primarily due to the LIBOR transition; however, coupled with other factors noted, there is expected to be, at least for some time to come, a pullback on the ability of banks to extend revolvers and credit lines like what obtained between 2019 to 2021.