Bank of England Governor Andrew Bailey: We need to learn the lessons of Libor, and ensure we complete this transition in a way that minimises the risk of us having to undertake a similar exercise in the future.
The Secured Overnight Financing Rate (SOFR) was identified by the Alternative Reference Rates Committee (ARRC) as their preferred replacement for USD LIBOR. Unlike LIBOR, SOFR does not contain a credit risk component or a forward-looking term structure. This has spawned much industry discussion and given rise to new Credit Sensitive Rate (CSR) proposals. Most of these CSR’s generally seek to emulate LIBOR, but not all.
When determining which of the CSR’s are suitable, leading financial institutions should consider the interests of their counterparts, clients, regulators and the American economy at-large, including non-financial corporations. Another basic requirement of any CSR is sustainability in the face of future regulatory changes or evolving market conditions. In the words of Bank of England Governor Andrew Bailey, “We need to learn the lessons of Libor, and ensure we complete this transition in a way that minimises the risk of us having to undertake a similar exercise in the future.”
An approach to credit sensitivity that factors in the volume of longer-term bank funding transactions which occur further out the yield curve results in a spread that is less volatile than LIBOR and is representative of actual bank funding costs. Crucially, this representativeness and robustness would be maintained over time, automatically adapting to any potential changes in bank debt maturity profiles.
This approach is the basis for the Across-the-Curve Credit Spread Index (AXI), which was discussed at a series of credit sensitivity workshops hosted by the Federal Reserve Bank of New York. AXI was conceived in an academic paper by Professor Antje Berndt, Professor Darrell Duffie, and Dr. Yichao Zhu. Since AXI is a spread added to SOFR, it leverages the almost decade long work of the ARRC and benefits from the strong foundation that SOFR represents.
“Crucially, this representativeness and robustness would be maintained over time, automatically adapting to any potential changes in bank debt maturity profiles.”
There are also additional macroeconomic efficiencies to be realized by an across-the-curve approach. Referencing a wider and deeper pool of transactions creates a spread that reflects a broader range of credit conditions. This reduces the likelihood and severity of sharp increases in short term rates driven by liquidity events, which have plagued LIBOR in the past, often crippling markets. AXI represents a more stable and moderate compromise between lenders and borrowers.
One such period of short-term bank liquidity stress occurred in March of 2020, when the U.S. Federal Reserve dramatically cut the Federal Funds Rate to support the American economy at the onset of the COVID-19 pandemic. At the same time, LIBOR spiked in response to short term bank funding liquidity constraints. LIBOR’s sharp rise during this period exacerbated the economic problems in myriad ways at the worst possible time. Under AXI, banks would not charge corporate borrowers higher interest payments in times of bank funding stress. This is because unlike LIBOR, AXI is not limited to the short-term unsecured funding markets that have withered away since the global financial crisis and is therefore not vulnerable to short-term illiquidity effects.
Reducing the likelihood and magnitude of this type of countercyclical scenario would increase the efficiency with which the Fed’s monetary policy decisions feed through to the real economy. Addressing the demand for a CSR while not relying on the markets that once underpinned LIBOR would go a long way toward ensuring easier and fairer financial conditions for those who need the most help during a financial crisis.
Fed Chair Jerome Powell has stated more than once that the recent economic downturn has not fallen evenly on all Americans, and those least able to bear the burden have been the hardest hit. At a time where the U.S. is re-establishing its position of leadership on a number of key global issues, lets also choose to be leaders in LIBOR transition. Even though it may be a bit more difficult in the short term, lets transition from LIBOR fairly, sustainably, and with a longer-term focus from which we will all ultimately benefit.
Marcus A. Burnett is the Chief Executive of SOFR Academy, a U.S based education technology firm and data provider serving corporations, financial institutions, governments, regulators and individuals. The Firm’s panel of advisors include academics from Harvard University and the MIT Sloan School of Management. Learn more about AXI at SOFR.org.AXI. This article was first published in Lexology.