Secrets and Libor fallbacks

Some things are better not shared. Like shoes, Risk.net logins and a bank’s cost of funds. Lenders may be forced to reveal this closely guarded information, however, when Libor ceases to be published.

Cost of funds is the ultimate interest rate fallback in the Loan Market Association’s standard documentation, which is widely used for syndicated and bilateral corporate loans governed by UK and European law.

There are several problems with this. First, the LMA documentation does not define cost of funds or how it should be calculated. Given its use as a proxy for Libor, the term is generally interpreted as the cost of borrowing in the short-term interbank markets. But banks no longer fund themselves in this way. According to the Bank of England, the proportion of balance sheet assets reliant on wholesale funding dropped from more than 40% in 2008 to less than 25% in 2017.

As a result, most banks now factor in other liabilities, such as retail deposits and long-term debt, when calculating their overall funding costs for lending. Some may even argue that loan loss reserves and capital requirements should be included in the costs passed on to lenders.

Even if a common approach to measuring cost of funds could be agreed, banks want to keep that information tightly sealed. A lender with low funding costs may face a backlash from customers for charging higher rates. More worryingly, a bank that pays above the odds would face questions about its creditworthiness and find itself locked out of the funding markets altogether.

All of this means cost of funds simply isn’t going to fly as a Libor fallback for loans. “I cannot ever envision individual banks publishing cost of funds,” says the head of credit and lending at an international bank. “That would not happen, full stop.”

Banks are now scrambling to insert alternative fallbacks into loan agreements. That’s easier said than done. While derivatives will switch to a compounded-in-arrears version of new risk-free rates plus a fixed spread, the loan market is clamouring for forward-looking term rates with a spread adjustment that more closely mirrors the credit component of Libor. These may take some time to emerge.

In the UK, forward-looking term versions of Sonia, the sterling Libor replacement, won’t be available for use until the end of the third quarter. In December, the working group on sterling risk-free reference rates launched a consultation on credit adjustment spread methodologies for fallbacks in cash products, which is likely to take even longer to conclude.

Some are now suggesting the loan market should simply adopt the fallbacks for derivatives instead. But the International Swaps and Derivatives Association’s fallback methodology fixes the effective bank term lending or credit component, and will create winners and losers when used as a reference rate for long-term assets.

Loan market fallbacks upend lenders

This should in theory be subject to compensation. But as Marc Henrard, managing partner at muRisQ Advisory writes, this is by no means a straightforward calculation, as shown in the non-cleared swaps market.

Using basis levels from before the Isda fallback consultations started moving the market, Henrard shows that a 30-year Libor swap rate without fallbacks should be up to 10 basis points higher than current levels.

All this involves complicated modelling, which might be ok to explain to a derivatives counterparty, but perhaps not to a small business owner wondering why the bank wants to change the terms of a loan. And if a dispute over compensation goes to court, Henrard believes a judge would throw out the Isda fallback in favour of a benchmark with a dynamic credit risk that changes over time, such as Ice Benchmark Administration’s bank yield index or Ameribor.

Libor fallbacks, like shoes and logins, are perhaps better not shared. Banks will need to find an appropriate alternative to cost of funds in loan agreements, and quickly.