On top of the myriad important considerations that non-financial corporates (NFCs) must think about when negotiating with their banks on loans (i.e., debt/EBITDA, fixed charge coverage, and negative covenants), management teams are now going through a once-in-a-lifetime transition from primarily the London Inter-bank Offered Rate (LIBOR)-based markets to alternative reference rates. While it can be challenging to understand the implications of agreeing to certain new rates, there are some core considerations that can help simplify the process.
Interest rate markets coalesced around the use of LIBOR decades ago for no other reason than its relative simplicity; it was meant to represent the average cost of funds of several large banks in London that were active in lending and derivatives. Reductions in the use of the unsecured markets that underpin the production of the rate created opportunities for manipulation given the small number of data points and the large dollar values at risk. In response to this, central banks around the world convened working groups to select rates that were risk-free (i.e., not reliant on bank funding costs) and robust in their calculation. The Alternative Reference Rates Committee (ARRC) selected the Secured Overnight Financing Rate (SOFR) as the recommended alternative for the USD market. Numerous vendors, in response to requests from banks to have rates that are “credit-sensitive” or reflective of an average bank cost of funds in the unsecured market as LIBOR was meant to be, have created alternative rates for this purpose.
SOFR is constructed from a robust pool of transactions in the treasury repurchase (“repo”) market. On any given day, there are typically more than 5,000 transactions in this market with total dollar volume of more than one trillion. The Bloomberg Short-Term Bank Yield Index (BSBY) and a recently launched offering from IHS Market, the USD Credit Inclusive Term Rate (CRITR) and Spread (CRITS) are both based on markets similar to LIBOR, primarily CP and CD transactions in the unsecured bank market, although they have enhanced the data collection methods. Volumes in these markets tend to average around $10-$15 billion in the key three-month tenor. Ameribor is based on overnight unsecured loans executed by banks that are members of the American Financial Exchange. Volumes here are in the single digit billions.
Why do certain banks prefer credit-sensitive rates (CSRs)? In times of market stress, CSRs tend to move higher relative to policy rates as determined by the Federal Reserve. For many institutions, this is an important factor as they are concerned that borrowers may look to increase borrowing during times of stress. Having the ability to change the rates that are available to borrowers is an efficient “macro hedge” for these banks. However, regulatory changes since the financial crisis from 2007-2008 have changed the construction of bank balance sheets. Banks are not able to use these markets to the same extent as they did in the past, as regulators do not want banks reliant on short term unsecured markets. According to Federal Reserve data, the percentage of bank liabilities that are based on unsecured markets has declined to approximately 2-3% of total liabilities.
One other concern from banks and end-users has been the lack of a term structure, or forward-looking component, for SOFR as it is based on overnight transactions. Most NFCs and many of their banks would prefer a rate that is determined at the beginning of an interest period. CSRs all have a forward-looking component, and this has increased their attractiveness as alternatives. It is important to consider that the ARRC is close to a recommendation for a forward-looking term SOFR, with recent public statements from regulators implying a launch as soon as the next month. The CME is already producing a term SOFR rate, and it has been selected as the vendor when the ARRC finalizes this recommendation.
When discussing the rates referenced in a loan contract, NFCs should ask reasonable questions of their counterparties:
- What rate are you proposing?
- Why have you decided to choose this rate?
- Is my company able to get multiple quotes for different indices?
- If it is a credit-sensitive rate, why is my company paying for the risk management of your balance sheet?
- Are there other alternatives to managing the funding risk on your balance sheet?
- Given recent statements from regulatory heads about CSRs, have you done an analysis of the regulatory risk of using specific rates that you are proposing in my contract?
These conversations are complicated, but basic knowledge is readily available. The ARRC has produced several documents to assist NFCs in these decisions. Engaging an advisor in this process can also help in bringing needed expertise to a complicated, but hopefully once in a lifetime, negotiation process.
For more information about LIBOR, visit AFP’s LIBOR resource page.
About the Author: Peter Phelan is the president of Phelan Advisory LLC, an independent advisory firm which works with banks, asset managers, and non-financial corporates on strategic initiatives. He was most recently the deputy assistant secretary for Capital Markets at the U.S. Department of the Treasury, where he represented the department as the ex-officio member of the ARRC. Peter also led the department’s work on credit-sensitive rates. Prior to his time at Treasury, he spent 25 years in senior roles in banking where he led balance sheet and capital markets teams focused on interest rate and derivatives products.