Lenders, LIBOR, and the move to the risk-free SOFR rate: seven takeaways for financial services firms

Even though many banks have urged that a way be found to integrate a credit risk premium into any replacement for LIBOR, at present, only SOFR has widespread acceptance as an alternative to LIBOR in the US market. While other solutions may emerge, it is unlikely that any other US ARR will gain real traction before the Fed’s transition milestones, which are fast approaching. Some market participants may eventually choose to turn to a different benchmark — and if one appears viable, you may want to explore it. But for now, there is no meaningful alternative to SOFR. With time running out, you should prepare to adopt it.

Successful RFR lending requires new pricing strategies, both to help minimize risks (especially during times of economic distress) and to manage your balance sheet. You may find that you have more options than you think when pricing SOFR-based loans (e.g. using non-zero floors), staying competitive and protecting your margin. Before the transition milestones arrive, you’ll want to have identified the new pricing strategies that fairly and transparently distribute the new risks, modeled how they might affect your particular portfolio, and then negotiated terms accordingly with counterparties.

When your loans are indexed to a new, risk-free rate, your funding and risk management strategies must adjust too — else mismatches could create new balance sheet risks. By changing your approach, you can create a far better alignment between lending and funding. To do this, you will need to make adjustments from a market risk and operational perspective — most likely, by moving to hedge risks with SOFR swaps rather than LIBOR swaps. It may become even harder to manage risk after the end of 2021, once all new loan production is tied to alternative reference rates such as SOFR. As LIBOR liquidity decreases in the market, there could be considerable volatility in whatever instruments remain.

To avoid reputational and conduct risk, make sure that both corporate and retail clients understand the coming changes in their legacy contracts, in the new loans you plan to offer, and in the marketplace. When communicating, take into account different clients’ differing levels of sophistication, and be empathetic: many business clients are still under great stress as they navigate the economic downturn. As with other areas, there are operational concerns to be managed, but you’ll also want to pay attention to the strategy.

For now, there’s little expectation of a uniform convention for loans based on SOFR. Different conventions — simple averaging, compound averaging, calculated with lags, shifts and lockouts — may be used for different contracts. To the degree that there is a consensus approach, we see firms gravitating toward simple interest; its implementation is likely more straightforward and it is likely more accommodating to prepayment. But you’ll want to make sure that your internal systems are operationally ready for these multiple conventions, and decide which convention you will prefer for each type of loan.

Whether it’s the challenge of multiple SOFR conventions, the need to adjust platforms, accounting and reporting, or the adjustments of legacy loans, make sure that your vendors are prepared — and that their updated systems will integrate with yours. Remember that some vendors may be juggling conversions across multiple currency-tenor pairs around the world. Given the tight deadlines, you may want to develop your own tactical solutions in case your vendors’ systems are not fully operational and aligned with yours in time.