During an economic downtown, LIBOR (and the interest rate on a LIBOR-priced loan) would likely increase. Because SOFR is a rate based on transactions secured by U.S. Treasury obligations, it's possible that during an economic downtown SOFR (and the interest rate on a SOFR-priced loan) would not increase and would in fact decline. Thus, in times of economic stress, a bank's income from its SOFR-priced loans would decline, while its funding costs would increase.
As a result, some banks believe that the interest rate on SOFR-priced loans should be subject to increase by an additional spread that would reflect credit risk at a particular time.1 Market participants discussed the construction, use and implementation of such a credit-sensitive supplement during a series of recent meetings at the Federal Reserve Bank of New York. In the most recent such meeting, representatives of the borrower community expressed their views and pointed out some of the problems that they see with a credit-sensitive supplement to SOFR.
On September 18, Nathanial Wuerffel, a Senior Vice President at the Federal Reserve Bank of New York, spoke about the concerns raised by borrowers.2
Borrowers' concerns about a credit-sensitive supplement to SOFR include:
Undermining a borrower's choice of banks. A borrower frequently chooses the banks from which it borrows based on the banks' credit profiles. A broadly-based adjustment to interest rates based on overall bank credit risk might include credit risk that is inconsistent with that of a borrower's chosen banks. Borrowers would not be able to mitigate the increase in interest rates during an economic downturn by their selection of banks.
Duplicating interest rate floors. Lenders currently employ a number of mechanism to manage risk, including interest rate floors. Borrowers question why interest rate floors cannot address banks' concerns with SOFR. Borrowers also ask whether, for SOFR-priced loans with a credit-sensitive supplement, interest rate floors shouldn't be modified or eliminated.
Impairing ability to hedge. Many borrowers hedge their interest rate exposure. Adding a credit-sensitive supplement to the interest rate on a loan could impair the effectiveness of a borrower's effort to hedge its interest rate exposure on that loan.
We expect to hear more from borrowers as the views of banks about the importance and structure of a credit-sensitive supplement develop.
Footnotes
1 Some banks have stated that such a supplement should be ". credit-sensitive, dynamic, based on unsecured funding, and reflective of marginal bank funding costs." See Wuerffel remarks at note 2.
2 Nathaniel Wuerffel, Transitioning Away from LIBOR: Understanding SOFR's Strengths and Considering the Path Forward, remarks at the Bank Policy Institute's Credit-Sensitive Benchmark Symposium. Available at www.nyfed.org/newsevents/speeches/2020/wue200918.
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