November 12, 2020 - In the past week, there have been several missives from regulators to banks, which seem to boil down to, “Get going on LIBOR transition, but we won’t hammer you if you don’t only use SOFR”. We discuss what the regulatory missives say – and share insight we’ve gleaned on why SOFR remains the base case in the leveraged loan space.
Last Friday, the Fed, OCC and FDIC released a “Statement on Reference Rates for Loans”, reiterating that “they are not endorsing specific replacement rate for LIBOR for loans” and that “a bank may use any reference rate for its loans that the bank determines to be appropriate for its funding model and customer needs”. However, the statement did give a nod specifically to SOFR, saying that the ARRC, “a group of private-market participants convened to help ensure a successful transition from LIBOR, recommended the Secured Overnight Financing Rate (SOFR) as its preferred alternative for both cash and derivative transactions.”
The letter also observed that the use of SOFR was voluntary and acknowledged that some banks may want to use a “credit-sensitive alternative to LIBOR”. But there are three key things to note here: First, most credit sensitive alternatives being discussed involve a risk sensitive adjustment over SOFR. Second, there is acknowledgement that it may be challenging to build, test and operationalize a risk sensitive adjustment prior to LIBOR cessation. In other words, it may broadly emerge after LIBOR cessation. Third, based on informal discussions with large bank agents, we are not hearing significant appetite to use other alternatives like Ameribor in the broadly syndicated/traded loan market, though they may well have more appeal in the small bilateral space.
To drill into the issue, the “Fed convened a “Credit Sensitivity Group“ to discuss risk sensitive rates; it has held four workshops thus far since the summer, and two more are in the works for remainder of the year. Risk Magazine points out that the CSG “is now assessing a range of “credit-sensitive indexes that can be layered on top of SOFR”. There are a number of risk sensitive SOFR adjustments being developed, including the ICE’s Bank Yield Index, the AXI, which is being developed by a group of academics, and potentially one from Markit. Thus, while risk sensitive spread adjustments are being considered, most still are underpinned by SOFR.
And this discussion must not slow anything down. While the regulators made clear that “[e] xaminers will not criticize banks solely for using a reference rate, including a credit sensitive rate, other than SOFR for loans”, they also are crystal clear that this is not an excuse for delay. The agencies “encourage” banks to begin transitioning loans away from LIBOR “without delay”. The OCC, meanwhile, was more direct. In this week’s Semiannual Risk Perspective, the OCC reiterated that it will “increase its oversight, particularly for banks with significant LIBOR exposure or less-developed transition processes.”
Our less formal interpretation: Get cracking, people!
