US Libor transition officials stumped on how to build bank credit risk into replacement rate

The US Libor transition has been slowed by policymakers’ inability to incorporate a bank risk premium into the replacement benchmark to make it more attractive to market participants.

“If anyone can figure out a credit spread, we haven’t, and we are a big group of people, about 800 people in the market,” said Tom Wipf, head of the US Federal Reserve-sponsored private-sector panel overseeing the US dollar Libor switch.

Wipf, the Alternative Reference Rates Committee chief, added at a recent government forum that “neither ARRC nor any private institution has been able to find enough underlying credit transactions“ to meet international standards.

He urged market participants to “think more creatively” on how to properly equalize Libor’s higher interest rate and that of its market-based replacement, the Secured Overnight Financing Rate (SOFR).

— Credit-risk component —

The thin market for scandal-plagued Libor has prompted regulators to undertake a massive re-engineering plan to replace it with SOFR by the end of 2021. But Libor has certain advantages that are giving US market participants pause about switching to SOFR, an overnight rate based on US Treasury repurchase agreements.

A credit-risk premium is included in Libor, making it higher, because it is an unsecured interbank funding rate. In contrast, SOFR doesn’t need this component because it is collateralized by Treasury bond holdings.

— Federated Investors view —

Deborah Cunningham, a Federated Investors executive vice president, said that the investment manager would be less likely to buy floating-rate issues that reference SOFR because of its lower rate.

“Frankly, I’m less compelled to own them in the first place without some type of additional spread all the time based on what might be instead of what has been,” said Cunningham, who spoke at the same forum as Wipf.

The International Swaps and Derivatives Association has solicited feedback from derivatives market participants on whether to use a historic mean or median to build a credit-risk premium for SOFR.

Cunningham said floating-rate issues would likely be in demand during a financial crisis.

“As a liquidity manager, I’d be more compelled to try to likely sell these securities in periods of stress,” Cunningham said.

But floating-rate bond owners would receive less compensation than if the bonds were tied to Libor rates, she said.

“It’s definitely less than ideal,” Cunningham said.

Pittsburgh-based Federated is one of the biggest investment managers in the US with about $460 billion in managed assets at the end of 2018.