The London Interbank Offered Rate (Libor) is being phased out and banks need to transition to alternative standards by the end of 2021. In July 2017, the Financial Conduct Authority (FCA) in the UK announced the discontinuation of Libor after certain banks provided interest rate figures which did not truly reflect the rate at which they could borrow. This led to the distrust in Libor as an indicator for the real health of the global economy. Banks manipulating the rate were ordered to pay fines.
The CEO of the FCA said that after 2021, the FCA will no longer “persuade or compel” banks to submit the rates required to calculate Libor. The Bank of International Settlements (BIS) says interbank trading has plummeted, especially in the unsecured segment. This was in part driven by quantitative easing.
Also, after the pandemic hit, banks repriced the risks associated with unsecured interbank lending, reflecting higher balance sheet costs due to tighter risk management and implementation of the new regulatory standards. “Interbank market activity is thus unlikely to recover much, even if central banks decide to reabsorb such excess liquidity,” BIS says.
As a result, in major currency areas, the authorities have already started publishing rates intended to eventually replace (or complement) the interbank lending rate (Ibor) benchmarks. The initial focus has been on introducing credible, transaction-based overnight risk-free rates (RFRs) anchored in sufficiently liquid money markets. Instead of Libor, and the general Ibor-centred rate regime, European and US banks are transiting to new benchmarks such as SOFR, SONIA, ESTER, SARON and TONA (see table: “Alternative risk-free rates in major currencies”).
Benchmarks derived from actual transactions in active and liquid markets; offer a reference rate for financial contracts that extend beyond the money market; and serve as a benchmark for term lending and funding, according to BIS.
Problems for banks?
The secured overnight financing rate (SOFR) reflects actual, short-term rates only after policy rate actions, unlike survey-based Libor, which is anticipatory. For example, three-month Libor began declining in late-February 2020 as the market overwhelmingly predicted a rate cut at the Fed’s March meeting, but SOFR responded only the day after the Federal Open Market Committee meeting by dropping precipitously.
“SOFR’s 90-day average, until forward-looking term rates emerge, will reflect historical trends, whether compounded in arrears or in advance. This may not be an urgent issue with US interest rates likely to remain low in the near term. However, when rates begin to rise, the inherent lag could result in banks lending off a lower benchmark than their wholesale cost of funds really are,” notes Fitch Ratings in a recent report.
Banks are already under margin pressure as policy and risk-free rates are at their lowest in decades. Any further disruption for their net interest margins, such as higher funding costs while lending off risk-free SOFR-based rates, would impact profitability to an extent that banks could report precipitously lower net interest income. Spreads between 90-day SOFR and three-month Libor have averaged less than 25 basis points (bp) since the market stabilised in June.
“However, a 25bp or even 5bp shift in relative lending rates among banks may not simply be a bank tolerating lower yields or thinner margins: in an environment of flush liquidity chasing limited quality assets, the switch to SOFR may price a bank, whose cost of funds hinges on short-term wholesale rates, out of competitiveness,” Fitch cautions.
Pricing on banks’ liabilities (term deposits and debt securities) reset more slowly than floating-rate assets and this lag can be exacerbated by a SOFR that is backward-looking, Fitch says. Average tenors of bank assets (including loans) are also much longer than liabilities (such as deposits), making the development of a SOFR term structure important for banks to manage some of these mismatches. Until a deep and liquid SOFR derivatives market emerges, there could be temporary disruptions in banks’ ability to pass on to customers or hedge these interest rate risks.
The threat to European, US and Australian banks is because they obtain a larger part of their funding from wholesale funding sources, unlike Singapore banks, which are deposit-funded. Based on 1H2020 results, DBS Group Holdings’ loan-to-deposit ratio was 84%. Of this, current account savings accounts (Casa) comprised more than 59%. Wholesale funding made up just 10% of total funding. Similarly, the loan-to-deposit ratios of Oversea-Chinese Banking Corp (OCBC) and United Overseas Bank were 85.4% and 85.8% respectively. Their Casa ratios as a proportion of deposits were 56.7% and 49.5% respectively, and wholesale funding comprised 9% and 13% respectively of total funding.
Are Singapore banks in a stronger position?
Not necessarily. The Singapore Overnight Rate Average (Sora), like SOFR, is a risk-free rate, and backward-looking. Effectively, Sora is the volume-weighted average rate of borrowing transactions in the unsecured overnight interbank SGD cash market. Hence, Sora, too, is fundamentally different from Sibor and Swap Offer Rate (Sor). “
Sora is a lagging rate that is riskfree; it carries no credit-risk premium or term-risk premium. Sibor and Sor are forward looking rates and their onemonth, three-month and six-month rates have both credit-risk and termrisk premia [built] into them,” Samuel Tsien, CEO of OCBC, explains in a recent webinar.
No surprise, then that risk-free rates are lower than non-risk-free rates. Hence, Sora is usually around 30bps lower than Sibor (see chart: “Three month Sora vs Sibor”) and around 40bps lower than Sor.
“On average in the past three years, Sora is 37 bps lower than Sibor and 48bps lower than Sor. When Sora is used for customer loan pricing, the spread quoted for the customer is higher than that with Sibor and Sor. The higher customer spread is not because earnings spread by banks have increased,” Tsien explains. “Final interest rate payments should work out to be the same [as they would have been with Sibor and Sor] over the lifetime of the loan,” he adds.
The initial Sora loans publicised by the banks and their customers carry larger spreads so that the cost to the borrower remains largely as though the loans were Sor-based.
In June this year, OCBC and CapitaLand announced the first Sora-based sustainability loan for $300 million. According to the press release, for Sora, the observation period is for five business days, before the first day of the interest period. The daily Sora rates are compounded in arrears over the observation period.
While not divulging either the interest rate or the spread, the OCBC– CapitaLand announcement said the interest amount is the product of the outstanding principal, compounded-in-arrears Sora and an applicable margin; and number of days in the interest period divided by 365. The interest amount is determined after the end of the observation period.
To date, Sora has been very stable, and the Monetary Authority of Singapore, the local banks and qualifying full banks are easing their customers into the new regime. The problem could arise when customers start negotiating for lower spreads. This would cause banks’ net interest margins (NIMs) to come under further pressure.
As it is, quantitative easing and rock-bottom risk-free rates as set by the Fed have already pressured margins. And, net interest income still comprises more than 50% of local banks’ operating profit.
In Singapore, Sor-based loans and products will cease by December 2021, and Sibor will be discontinued after 2024. The Sor fall-back rate will be published by the Association of Banks in Singapore (ABS) or three years from end-2021 depending on the market. To ease the transition, Sor and Sora can coexist for a few quarters, but banks are recommended to avoid having a large Sor book.
