Getting Ready For LIBOR Transition
On October 23, 2020, the International Swaps and Derivatives Association (ISDA) published the much anticipated IBOR Fallback Protocol (Protocol). Firms that sign up for the Protocol agree to the spread adjustment and the fallback rates if LIBOR becomes unavailable in the future. Most community banks have some loans or deposits tied to LIBOR, and many community banks have used LIBOR hedges to help borrowers manage interest rate risk. Community banks need to understand the implications of the Protocol on economics, documentation, and cash flow processing for these LIBOR-based products. In anticipation of Libor going away, CenterState Bank has executed Secured Overnight Financing Rate (SOFR)-based notes to test our various systems’ ability to handle SOFR. We have identified some essential concerns that we want to share with our readers to help our banks make the potential adjustment.
LIBOR Fallback Protocol
Firms that adhere to Protocol agree that the terms of their covered documents (both ISDA and non-ISDA documents) will be amended in accordance with the terms and subject to the conditions set forth in the Protocol, and more specifically, Supplement Number 70 published on 10/23/20. Central clearinghouses are required by law to adhere to the Protocol. It is anticipated that virtually all of the major broker-dealers and national banks will adhere to the Protocol. Adherence to the Protocol avoids uncertainty, decreases the risk of litigation, and provides a market-neutral distribution of risk and yield.
The Protocol incorporates specific rates and definitions for LIBOR transition as follows:
- LIBOR will be substituted with SOFR.
- SOFR will be adjusted to make it economically equivalent to LIBOR. ISDA will take the median difference between SOFR and the specific term LIBOR over a five-year period from the LIBOR cessation trigger date.
- The spread adjustment calculation will take into account both compounding differences (SOFR is a daily rate, while LIBOR represents term structures (one month, three months, etc.)), and the credit adjustment (SOFR is a risk-free rate, and LIBOR includes a credit component).
- Adherence to the Protocol will apply to ISDA and to non-ISDA documents.
- Entities that agree to the Protocol agree to the adjustments, triggers, and definitions published by ISDA firm-wide and will not need to negotiate these terms bilaterally.
- Most importantly, the Protocol defines the calculations, the accrual, and rules for the fallback rate adjustments – the published rule book is very specific on all calculations.
It is anticipated that nearly all broker-dealers and national banks will adhere to the Protocol, but most end-users of LIBOR products will not (commercial and consumer bank customers). It is expected that community banks that have common commercial fallback language in their cash products (loans and deposits) and hedges will also accept the Protocol to align the economics of their LIBOR instruments with the market in order to avoid economic redistribution between counterparties.
There are two adjustments to SOFR: first, SOFR is a daily rate and must be compounded for the payment period, and second, SOFR is a risk-free rate and must be adjusted for the LIBOR-credit risk component. The credit risk adjustment is accomplished through a spread adjustment published by various sources (including Bloomberg). For example, on 10/23/20, the 1-month LIBOR rate was 0.15625%, and the spread adjustment for that tenor was 0.11448%. If LIBOR were to cease on that day, and an entity adhered to the Protocol, the new rate would be daily SOFR (0.07%) plus the spread adjustment of 0.11448%, or 0.18448%. SOFR would change daily, and the same spread adjustment would be added until the termination of that contract.
The more serious concern for community banks is the adjustment of SOFR for daily compounding. Daily interest rate calculations can be simple interest or compound interest. For simple interest, the annual rate is divided by the number of days accrual and interest accrues on principal outstanding per diem, and the dollar amounts per diem are added. For compound interest, the interest on interest is added to the per diem until payment is made. The Protocol only defines compounding interest calculation for SOFR. However, most community bank core systems currently cannot accommodate accrual based on daily compounding interest. Two adhering parties to the Protocol must use compounding SOFR calculations unless both parties agree otherwise.
We analyzed the difference in accrual for simple daily interest, compound daily interest, and adjustable interest (resetting SOFR at the beginning of the payment period and applying that interest for the entire period). We also ran scenarios based on various SOFR rates and assumed increasing and decreasing interest rate environments. Summary of our analysis are as follows:
- Compounding interest results in higher accrual than simple interest if SOFR is greater than zero. However, the difference is extremely small when SOFR is at today’s levels. Based on SOFR at 0.10%, compounding results in 10 cents more accrual per year on a $1mm loan. With SOFR at 5%, compounding results in $105 more accrual per year on a $1mm loan (still not a material difference of only 0.14% difference in total interest accrual).
- Adjustable interest is the same as simple interest if rates are steady. However, assuming a 100bps increase in rates per year, on a $1mm loan, compounding interest accrues $506 more per year than adjustable accrual (0.69% total difference in interest accrual).In a decreasing interest rate environment, the exact opposite occurs, and adjustable interest accrues more than compounding interest.
Many community banks cannot currently calculate compounding daily interest in SOFR based notes and deposits on their core system. Where the banks have adhered to the Protocol, they may be unable to calculate interest as required by adhering parties and will need to seek consent to calculate interest on simple or adjustable interest rates. The difference between simple, compounding, and adjustable interest rates may not be material depending on assumptions related to the absolute level and direction of movement SOFR. However, community banks must now consider this impact and assess this risk. Regulators, for example, will want to see that your bank has a plan for converting Libor to SOFR and have identified the risks.
Operationally, adjustable accrual is easiest for banks to manage. Almost all core systems can deal with daily simple interest calculations, but currently, many core systems are unable to calculate daily compounding interest, which is the only method acceptable for the Protocol. Knowing when your core system will be able to handle daily compounding interest is important to know in case Libor does go away or in case you need to purchase/sell a SOFR-based instrument such as a loan participation, loan/balance sheet hedge, or deposit.
Even if you don’t deal with a SOFR-based instrument, having a working knowledge of SOFR will be critical as it will be the index that best tracks your cost of funds and will likely become the new basis on which you benchmark your balance sheet for items like asset-liability monitoring, profitability calculations, and balance sheet valuation. Since a banker’s stock and trade is interest rates, bankers must understand how the global banking industry is transitioning away from Libor and how this new index works.