Challenges in using SOFR for all loans
Bank funding risks
Many of our clients are asking about the impact of using risk free rates such as SOFR and SONIA in loan products which allow for discretionary drawdowns. This is especially challenging in the case of revolving credit facilities and particularly those with multi-currency options.
The choices of when, how much and which currency a bank can allow a borrower client to draw down in certain products has always been a challenge to manage. For example, in times of significant stress (e.g., GFC and COVID) the clients can suddenly draw cash from revolving facilities which can create liquidity and pricing problems for the banks.
In the past, the pricing of these facilities was somewhat easier because the reference rates were intrinsically linked to credit-sensitive benchmarks such as LIBOR. When liquidity and credit was stressed, LIBOR typically rose faster than Fed Funds (i.e., the TED spread increased) and the pricing of the loan facilities reflected the increased cost for the banks. This was automatically transferred (in the most part) to the borrower as the reference rate (LIBOR) closely tracked the bank’s borrowing rate.
This affected the bank profitability, the cost of the loans based on that expected cost/return and the behaviour of the borrowers. Banks could reasonably accurately price the facility based on expected costs (additional spread) and borrower drawdowns (expected liquidity requirements) and so were generally prepared to offer competitively priced products to clients.
The recent paper published on 22 December 2022 on the Federal Reserve of New York site and authored by Harry Cooperman, Darrell Duffie, Stephan Luck, Zachry Wang, and Yilin (David) Yang looks at the possible costs and therefore pricing challenges for banks when using SOFR rather than LIBOR for certain loans.
For those whose holiday calendar resulted in them missing this important paper, I really urge you to read the full transcript. In the meantime, I will outline some of the main points and my view of how these may impact banks and their clients.
One word of caution: the authors do note that the paper does not necessarily represent the views of the NY Fed or the Federal Reserve.
Bank Funding Risk, Reference Rates, and Credit Supply – Federal Reserve of New York – 22 December 2022
The paper references some very interesting data and does some really great analysis. The work focusses on the revolving credit loans that give borrowers the option to draw funds up to the credit limit at any time under agreed terms and pricing.
These credit facilities are widely offered by banks and are often used by their clients to guarantee funding for short periods of time even when liquidity conditions in the broader market may be challenging. It is this optionality and the very real likelihood that clients will require the funds at short notice in difficult markets that dictates the terms and pricing of the facilities.
The facilities tended to use credit-sensitive reference rates (e.g., LIBOR) which reflect the actual borrowing rates for the banks at a point in time. In this case, the underlying market conditions are automatically included in the LIBOR pricing for the clients and the banks can offer these products at competitive prices and terms.
The authors look at the impact of replacing LIBOR with risk free rates such as SOFR. They run some simulations for GFC (2008) and COVID (2020) and compare the performance of the products (LIBOR plus a fixed credit spread versus SOFR plus a fixed credit spread).
Without the credit sensitivity (i.e., using SOFR), the banks would be very likely to have a lower margin (NII – Net Interest Income). This was particularly evident in GFC (-6.48 billion) while the COVID experience was lower (-1.59 billion).
This is demonstrated in the following chart used by Ross Beaney previously.
These results can be found in Section D of the paper – Accounting Counterfactual Assumptions & Additional Results, Appendix D.
Why does this matter?
The authors conclude that the choice of reference rate (LIBOR or SOFR) affects the supply of revolving credit lines.
Under LIBOR referencing facilities, the bank and the client share the embedded liquidity risk. As the market supply of funds decreases, the cost increases (i.e., LIBOR rises relative to Fed Funds) are largely passed on to the borrower. The lender (the bank) still retains some risk as their individual ability to borrow funds from the market may be impacted by their own credit compared with other banks and this may diverge from LIBOR.
Point 1
This could result in the banks increasing the pricing for revolving credit facilities linked to SOFR or restricting the supply of these products. Because the risk is now firmly with the bank, the pricing and supply must reflect a ‘worst case’ scenario where the bank has limited ability to borrow from markets and/or an increased cost.
Note that this is not such a major issue for standard, term loans. These products can be term funded at a known margin and do not have the optionality for drawdown. In this case, there is little or no uncertainty about the principal and timing of the drawdown and repayment of the loan.
The authors do not consider multi-currency revolving credit facilities in their work. In my experience, the multi-currency option creates even more issues for banks and their clients. If you use a credit sensitive reference rates for the optionality within one currency (e.g., AUD BBSW) and a risk-free reference rate for another currency (e.g., USD SOFR), then under certain market conditions, one alternative could be far better than another for the borrower. For example, with a fixed spread to SOFR, if the actual market rate is above SOFR plus the fixed spread, then the rational borrower would logically opt for the USD.
Point 2
Multi-currency revolving credit facilities present additional problems for pricing and supply of the product. A bank must reasonably use the worst-case spread for a risk-free rate or risk being drawn on the facility when liquidity spreads exceed the fixed spread in one or more currencies referenced in the facility.
Is there another way to resolve this?
Fortunately, several credit-sensitive alternatives exist which could be used to replace LIBOR and be used with or instead of SOFR. We have previously written on this subject here, here, and here.
In the USD market these include:
Across the curve Spread Indices – SOFR Academy and Invesco
Bloomberg Short-Term Bank Yield
Credit Inclusive Term Spread/Credit Inclusive Term Rate – S&P Global – not yet available for licensing.
Published by AFX
I will not describe each of these alternatives, but the links are provided for further information if you are not already familiar with the reference rates. In all cases, they have reasonably tracked LIBOR in the past and add back a level of credit sensitivity.
If Messrs Cooperman, Duffie, Luck, Wang, and Yang are correct in their conclusion that SOFR-linked revolving credit facilities may be affected (I.e., negatively compared with the outgoing LIBOR equivalents), using the newer credit-sensitive rates above may help restore the risk balance. This may allow the banks to continue to offer these products as they do now.
Summary
The 22/12/2022 paper (and I appreciate the alliteration!) highlighted some particularly important challenges in the transition from LIBOR to SOFR for revolving credit facilities. The authors rightly point out that pricing and supply of these facilities may be negatively impacted.
While they did not look at multi-currency facilities, these present even more problems for banks who now provide these to clients.
Many end-user borrowers have such facilities to ensure they can have liquidity available under all circumstances. They may be expensive but are essential components of good risk management for many corporate and investor firms.
If the supply and/or price of these products is negatively impacted, there is a real risk that the end-users may face increased risk to liquidity crises in the future.