Bidding credit sensitivity adieu…
Credit sensitive benchmarks have been fundamental to corporate finance for many years. The loss of this sensitivity adds a systemic burden to deposit taking institutions. Why? Because corporate loan books no longer adequately reflect and compensate for the funding risk in the manner of the LIBOR-based system.
The magnitude of this mispricing depends on the extent to which corporate assets pervade bank balance sheets and the adjustment that bankers have made to lending margins. With banking sector credit risk returning to prominence recently, it is timely to look at this annoying, obscure, yet potentially impactful problem.
Our analysis concludes that while US banking market capitalisation has notably rebounded from GFC lows and appears capable of withstanding a major credit induced event; post-Libor risk-free rates may not adequately reflect the risk undertaken by lenders. This potential interest forgone is of a material magnitude.
Hypothetical Interest Forgone under SOFA during the GFC
We described some important work done by Professor Urban Jermann in our post of August 2022.
Professor Urban is Safra Professor of International Finance and Capital Markets at the Wharton School of the University of Pennsylvania, and we showcased his major work from 2021:
Interest Received by Banks during the Financial Crisis: LIBOR vs Hypothetical SOFR Loans.
This estimated the amount of interest that would likely have been forgone by US banks had US business loans been indexed to SOFR during the GFC:
“The cumulative additional interest from LIBOR during the crisis is estimated to be between 1% to 2% of the notional amount of outstanding loans, depending on the tenor and type of SOFR rate used”.
With cumulative interest forgone estimated at:
U$32.1 billion if loans had instead followed compounded SOFR; or
U$25.0 billion had they followed Term SOFR
To recap, these numbers represent the hypothetical interest income foregone if corporate facilities had been indexed against the major SOFR variants over the period 1st July 2007 and 30th June 2009.
To contextualise the GFC moves, 3m LIBOR versus 3m SOFR Overnight Index Swap (OIS) rates are plotted on the following graph. This credit sensitivity proxy is generally known as the LOIS spread.
The LOIS spread averaged 10.7 basis points for the five years prior to July 2007. This average LOIS spread rose to 89.1 basis points through the GFC, as defined by Professor Jermann.
A non-trivial amount
In a follow-up article in Knowledge at Wharton, editor-writer Shankar Parameshwaran highlights what Professor Jermann was driving at:
“The $30 billion in interest income due to the credit sensitivity of LIBOR is not a trivial amount”.
Inviting hurried back-of-the-envelope calculations, Parameshwaran calculates that:
“On March 6th, 2009, when bank share prices tanked, the top 20 commercial banks from 2007 had a combined market capitalization of $204 billion.”
According to NYU-Stern School of Business, forward price-earnings ratios for money center banks today sit at around 9x earnings.
Those wanting to interpolate what might have been should take care to note that Professor Jermann’s calculations were for hypothetical interest foregone over two years, whereas P/E ratios are based on annualised earnings measures.
Nonetheless, sector annualised interest forgone of between $12 and $17 billion (i.e., halving Professor Urban’s numbers) in an environment where stocks are trading on 9x multiples is very worrying, especially considering the sector market cap of only $204 billion.
2023 – What of the situation today?
Taking Professor Urban’s raw calculations and assumptions and applying sector asset growth, US banks across 2023/24 would likely forgo:
U$59.4 billion if loans follow compounded SOFR; or
U$46.3 billion if loans follow Term SOFR
This is a simple estimate if the credit moves of the GFC period are replicated in the coming two-year period; but system risk appears much lower given the expansive sector market caps.
For the sake of comparison, the market capitalisation of the 20 largest financials in the US sits today at around U$1.54 trillion at mid-March 2023 by Martialis calculations (U$1,541.29 billion to be precise). This represents an impressive rebound and growth of 755% since the height of the GFC.
Corporate lending has grown far less quickly.
According to the St Louis FED, total financial assets of the domestic US financial sectors grew only 85% over the corresponding period (a surprisingly large lag). For the sake of framing, it’s worth noting that the US economy is only a third larger than March 2009 in terms of annualised real GDP, so we’re within reasonable ballpark.
This suggests that the system could handle GFC like conditions, but that the interest likely forgone if GFC-like conditions re-emerge, is still quite material.
What of the latest credit stress event?
To simplify how we look at credit stress we’re starting to favour Invesco/SOFR Academy USD Across-the-Curve Credit Spread Indexes, known more generally by their acronym ‘AXI.’
AXI is starting to gain interest given its constituent make-up and methodology, and we like the clean picture of credit sensitivity it provides in USD:
AXI is a weighted average of the credit spreads of unsecured US bank funding transactions with maturities ranging from overnight to five years, with weights that reflect both transaction volumes and issuances.
AXI can be added to Term SOFR (or other SOFR variants) to form a credit-sensitive interest rate benchmark for loans, derivatives, or other products.
The historic picture of AXI across 1m, 3m, and 6-month tenors from 2018 is as follows:
Credit sensitivity is highlighted over the period of COVID market stress and more recently as bank funding costs have risen with the Silicon Valley Bank and Credit Suisse events of early 2023.
For those interested in further AXI resources, please refer to:
How is AXI tracking the current stress?
Here I compare 3-month AXI with 3-month LOIS (LIBOR-OIS) over an analogue period, starting 90-days prior to the largest jump above one standard deviation in LOIS from 2007, which occurred on 9th August 2007.
While the base of AXI commences somewhat higher than LOIS, at +19.3 versus +8.8 basis points in the ninety days to Day-0 (identified by the dotted red line), the credit sensitivity of the subsequent period shows remarkable similarities at the start of both periods of credit deterioration.
Conclusions
What is clear is that despite the move to risk-free rates (RFRs), rational investors remain rational; demanding higher risk premiums to compensate for the risk of funding banks.
What’s less clear is the extent to which banks are able to pass-on a higher cost of funds to cover their various assets; and this is a systemic problem.
While higher rates are almost uniformly beneficial across mortgage and smaller variable finance segments, it’s not clear how banks compensate for the absence of LIBOR-like credit sensitivity in their corporate assets.
With these points in mind, we encourage bankers to ask three questions:
How long will banking sector credit remain elevated?
Are we receiving sufficient compensation for corporate lending in a risk-free-rate world?
Should corporate loan margins be recalibrated accordingly?
Widespread failure to address these seems to us to have rather obvious consequences.