That Already High Hurdle Looks a Little Higher as the US Credit Sensitivity Group Continues to Make Its Case for a More Credit-Sensitive Alternative to SOFR

According to the minutes¹ of the facilitated panel discussion, the presentations² at the July 22, 2020, second meeting³ of the Credit Sensitivity Group,⁴ a group of regulator-convened US regional banks, reinforced the banks’ argument that a more credit-sensitive rate is required as an alternative to SOFR with the currently contemplated spread adjustment. However, the meeting also included presentations⁵ by representatives of the Federal Reserve that attempted to show that: (1) while LIBOR rose in March 2020, it rose less than during the 2007-9 financial crisis, and LIBOR did not rise “reliably” in the 2001 recession or the 1990-1 recession; (2) bank funding has migrated significantly from wholesale unsecured funding such as that which underlies LIBOR; (3) with “cheaper” deposits rising in times of stress such as the recent COVID-19 pandemic, risk-free rates are more closely correlated to bank funding than LIBOR, even in financial stress; (4) while banks do experience lending drawdowns during times of stress, for domestic banks, core (and cheaper) deposits also increase; and, finally (5) an easier way to ensure that lending rates do not fall during downturns is to use a floor for the applicable benchmark rate. However, the minutes show that meeting participants questioned some of these views.

Bank of America also presented⁶ and noted that changing a pro-cyclical rate (such as LIBOR) to a counter-cyclical rate (such as SOFR) would fundamentally change how banks allocate capital and would ultimately increase lending costs and reduce credit availability.⁷ Bank of America also noted that, from a credit risk perspective, averages of overnight rates are not the same as short-term rates since short-term rates also reflect that liquidity is at risk for the duration of the related period.⁸

Finally, Professors Berndt, Duffie and Zhu presented⁹ the findings from their paper¹⁰ regarding an “across-the-curve” (AXI) approach to estimating bank funding costs that may be a more credit-sensitive adjustment to SOFR than the current proposed spread adjustment.

The agenda¹¹ for the third and final meeting, on August 12, 2020, indicates that this meeting will cover the requirements for a robust reference rate, possible data sources for a credit-sensitive spread and related design and possible preferences for such a spread. The minutes for this meeting have yet to be posted.

However, with less than 500 days until LIBOR’s scheduled cessation, there is not a lot of time for market participants to coalesce and support a preferred credit-sensitive spread to SOFR or another benchmark rate so that the market has available an alternative to LIBOR that is “fit for use” for commercial and consumer lending.