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.
Frank Sansone, Treasurer, SVP, China Construction Bank
The Alternative Reference Rates Committee (ARRC) is a group of private-market participants convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition from U.S. dollar (USD) LIBOR to a more robust reference rate, its recommended alternative, the Secured Overnight Financing Rate (SOFR). The ARRC is comprised of a diverse set of private-sector entities that have an important presence in markets affected by USD LIBOR and a wide array of official-sector entities, including banking and financial sector regulators, as ex-officio members.
While the ARCC committee identified obvious benefits from SOFR as the preferred libor replacement benchmark, they also failed to identify and focus on the significant differences in the benchmark. As a consequence these benefits came at a cost to banks and full acceptance of SOFR is not without potential significant challenges. These challenges are created quite simply due to the lack of a credit component in SOFR. As we all are aware by now, SOFR is calculated by employing an average of US Treasury repos, a credit risk free rate. Libor is based on the risk-free rate plus a credit premium. This credit component is variable and as a consequence we have a risk-free benchmark for bank credit sensitive funding. SOFR is not a hedge for credit sensitive bank funding.
Banks have pushed back on the Fed and have won both recognition and acceptance in general for the requirement of alternative reference rates. As a consequence, there are a number of well thought alternative reference rates that do provide this credit component. Each is gaining some traction and while no one specific alternative is taking the lead it is providing options for banks to better manage this risk.
The “big bang” shift to a static CSA from a dynamic CSA will have significant implications for bank funding groups.
Historically banks hedged credit risks to banks funding and NIM with libor swaps, at least the systemic credit portion of a banks funding risk. As was demonstrated as libor jumped 200 + bps in the Great Financial crisis of GFC, in general banks funding costs/NIM was significantly hedged with Libor increasing commensurately. In the recent COVID systemic stress, once again libor moved consistent with bank funding costs and provided a significant hedge. However, once the final CSA is implemented, big bang, this systemic credit risk component will not be hedged with SOFR swaps.
Firms are outsourcing managing legacy contracts to external vendors and while this can provide both system and economic efficiencies, I am a strong advocate for internalizing as many systems and process wherever possible, particularly on transactions that require additional due diligence.
In fact, I would argue that SOFR will further complicate the process of funds transfer pricing (FTP). FTP is the process that best allocates profit and loss and risk among the relevant business lines. FTP has always been both a complicated and historically contentious topic in banks. With risk and revenues allocations at issue, FTP calculation has created disagreements within business units.
FTP has various components, the primary of which is the banks funding cost for that specific maturity of the asset or liability. Banks do not fund themselves at the risk-free rate for unsecured financings. As a consequence, calculation of a banks funding cost includes a credit component premium. Within this credit component there is both a systemic and idiosyncratic credit component. With libor the credit component has a systemic benchmark and a bank generally must include only its systemic credit component. Without libor, both credit components (systemic and idiosyncratic) of the banks funding cost becomes more subjective. Rest assured this will only further complicate the FTP calculation and allocation process.
Simply, where banks can automate it reduces the risks of human error. Reducing potential errors reduces the cost of operational risk.
Frank will be speaking at our upcoming Treasury and ALM USA Congress
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