Libor can no longer be used to price loans
- US and International Regulators are prohibiting banks from using the US dollar (USD) Libor indices to price almost all new loans effective January 1, 2022.
- While the Libor indices for most maturities are still being published daily, it may cease availability after June 2023.
Substitutes for US Libor
Several new and existing indices can substitute for USD Libor in pricing loans, these include:
- BSBY by Bloomberg
The Secured Overnight Financing Rate (SOFR) is the recommendation of Regulators (through the ARRC committee) and has gained broad market acceptance.
SOFR indices comes in a variety of terms and methods of calculations:
- Overnight - the basic SOFR and is based on daily repo transactions (primarily using US Treasury collateral) as reported to the NY Federal Reserve.
- SOFR averages in arrears - the geometric average over the last 30, 90 and 180 days of the overnight SOFR.
- Term SOFR - similar to term Libor, but based on movement (via the futures markets) of the overnight SOFR for the next 1, 3, 6 and 12 months, this is calculated by the Chicago Mercantile Exchange (CME).
During a period of low volatility in short term rates overnight and SOFR average in arrears are almost equal (see example from early 2022 below).
Average in Arrears compared to Overnight and Term
- SOFR averages represent what happened with SOFR in the past and does not represent present or future expectation.
- During a period of short-term rate volatility there can be a significant differences between the average SOFRs and the current Overnight SOFR.
After the mid March 2022 Federal Reserve rate moves, note averages will increase over time, but are lower than the new overnight level for some period (see example below).
- Term SOFR reflects what is likely going to happen to overnight SOFR over some specified term.
- These generally move in synch with or even in anticipation of changes in overnight SOFR.
- They can be thought of as a forecast of the future.
- Like Term Libor they can represent they cost to “borrow” funds for the term specified, assuming an organization can borrow at SOFR rates.
Why should a bank use overnight or term SOFR in loan pricing?
- An important component in loan pricing is the funds transfer (FTP) interest expense. In the PrecisionLender loan pricing solution, this typically represents the current market and not some prior 30 or more days average.
- Using an average index from the past on the interest income side with the current FTP can lead a sub-optimal interest margin requirements on floating rate loans.
- In a period of rising interest rates this margin may be too high compared to the current market-place, leading to loss of the deal to a competitor.
- In a period of falling interest rates the margin may be too low, resulting in less profitable lending.
- Suppose on March 14th , before any rate moves by the Federal Reserve, overnight and 30-day average in arrears SOFR is 0.05% and the cost of funds for a floating rate loan is 0.25% . In order to achieve a target ROE, the loan pricing solution recommends a spread of 3.00%.
- On March 23rd, a few days after a Federal Reserve rate increase, overnight and 30-day Term SOFR are 0.30% and cost of funds is now 0.50% . Pricing with this index the spread to achieve a target ROE would be 3.00%.
- However, the 30-day average in arrears SOFR would likely be about 0.10% on that date, thus the recommended spread shown on a pricing solution would be 3.20%. If using the average in arrears index.
- Eventually over the next 25 days, assuming no further increases in short term rates the 30-day average in arrears index would increase to about 0.30% and the suggested spread would decline to 3.00%.
- While a 3.20% spread would be more profitable to the bank, it might make the loan less competitive and more likely that the customer selects the competitor “bank down the street”.
- In a period of declining short-term rates, the loan pricing solution might suggest a spread of 2.80% for the 30-day average in arrears SOFR, shortly after any Federal Reserve announcement. This would result in a less profitable loan.
Selection of a Proper Index
- In loan pricing a financial institution should use an index that reflects present or future expectations, not past rate movements.
- While the average in arrears may be a reasonable index to use in calculating interest income for a floating rate loan once it is originated, it does not work well when initially used to model the pricing of a loan.
- The bank needs to decide which index to use within their loan pricing systems. Using an index on the income side whose movements are similar to the FTP expense cost is important in modeling the pricing of a loan.