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COMMERCIAL LENDING AFTER LIBOR Survey results
January 28, 202110 AM, US Eastern Daylight Time
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Dan RosenbaumPartner, LIBOR Services [email protected]
Adam SchneiderPartner, Lead of LIBOR [email protected]
Umit KayaPartner, Risk and [email protected]
Prerna GuptaLead Consultant, Lending Survey [email protected]
OLIVER WYMAN HOSTS
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1 Opening remarks
2 Survey background and key findings
3 Evolution of alternative USD commercial lending rates
4 View from the borrowers
5 Fallbacks and their role in establishing the future lending market
6 Where do we go from here?
AGENDACommercial Lending after LIBOR: Survey Results and Implications
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US REGULATORS HAVE A GOAL OF ENDING USD LIBOR LENDING AFTER 2021WITH THE RATE CONTINUING FOR EXISTING LOANS UNTIL JULY 2023
What’s At Stake: the LIBOR Commercial Lending Market1
USD LIBOR lending footprintApproximate Outstanding
($ Billion) % LIBORLow
($ Billion)High
($ Billion)
Syndicated loans2 $ 3,400 97% $ 3,298 $ 3,298
Corporate business loans2 $ 1,650 30–50% $ 495 $ 825
Noncorporate business loans $ 1,252 30–50% $ 375 $ 626
CRE/Commercial mortgages $ 3,583 30–50% $ 1,075 $ 1,792
Total $ 9,885 $ 5,244 $ 6,541
In the US, LIBOR is the predominant rate for commercial lending with $5-6 trillion of outstanding loansThe Federal Reserve has a goal of ending USD LIBOR usage and formed the Alternative Reference Rates Committee (ARRC) to champion the change. To facilitate, ARRC proposed a new rate, the Secured Overnight Finance Rate (SOFR) as its preferred replacement. SOFR has been successful in derivatives but to date SOFR lending is quite small.A number of key transition dates are approaching:• The ARRC’s “best practice” date to stop new LIBOR lending is June 30, 2021• Regulators have indicated LIBOR lending should end after December 31, 2021 except in rare cases• The USD LIBOR rate itself will be published until July 2023, with existing contracts then moving to “fallback” terms
1.Estimated based on industry and Federal Reserve surveys plus Oliver Wyman analysis2.Some overlap exists between estimates of syndicated and corporate business loans
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LIBOR is a forward-looking rate with multiple tenors, while SOFR is an in-arrears rate so not known in advance. LIBOR as designed reflects bank funding costs (although that is disputed), while SOFR is risk-free and tied to overnight repurchase transactions. The differences are crucial and there have been recurring concerns about using a risk-free backwards looking rate for lending
Given these two issues the ARRC set a goal of producing Term SOFR by the end of this 2021:
However there is no plan for the ARRC to address lender preference for any other rate. A number of lenders have pushed for a rate related to marginal funding costs, which we term a Credit Sensitive Rate (CSR). There are several contenders in the market today.
As we enter 2021 the future of base rate in commercial lending is murky. The vast majority of loans use LIBOR and there is no well accepted successor and less than 12 months before LIBOR cannot be used.
So, it’s a “horse race”, and so far the rate that is going away is winning!
Given the lack of clarity of the evolution, Oliver Wyman conducted a survey with market participants
“But while SOFR should be relatively easy to incorporate into derivatives, participants in many cash products may find use of an overnight rate unfamiliar […] To address this issue, the ARRC has explicitly included a goal of producing a forward-looking term rate for use in cash products.”
– ARRC Second Report, March 2018
THE TRANSITION TO SOFR FOR COMMERCIAL LENDING HAS BEEN SLOW
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OLIVER WYMAN SURVEYED THE US BANKING INDUSTRY TO UNDERSTAND CAUSES FOR THE DELAY AND LIKELY FUTURE PATHSSurvey Goals• Understand and discuss plans for USD commercial lending, including:
– Issues with and expected use of SOFR– Preference, if any, for a Credit Sensitive Rate (CSR)– Borrower preferences and reactions to date– The potential effect of LIBOR fallbacks on future lending– Future changes in lending products
• Provide us with information to make an educated assessment on future market evolution
Survey Process• Over 20 firms were interviewed including G-SIBs, FBOs, Regionals, borrowers, and trade groups• Lenders interviewed had >$10 trillion in assets• All responses were anonymized and summarized• Survey discussions started in October 2020 and ran through late December• Given regulatory announcements made November 30th, we paid particular attention to the go-forward situation. For the purposes
of this survey we assume the proposed changes to USD LIBOR timing are enacted.
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2021 will be the defining year in corporate lending transition and we expect LIBOR lending to lead for most of the year
After 2021 the choice of base rate is unclear as Term SOFR and all of the Credit Sensitive Rates (CSRs) need further development
If none of these emerge by the end of 2021, lenders will use in-arrears SOFR on an interim basis – creating a “valley of uncertainty.” We continue to believe a Term rate will dominate
There is a risk of NIM compression while both LIBOR and SOFR are visible. While SOFR loans should have higher “all-in” rates we expect borrowers to seek the same rate regardless
Fallbacks need to be re-examined as the ARRC hard wired waterfall is static. With ~2.5 years before they execute hard-wired fallbacks may misprice if lending moves to a CSR
We believe a multi-rate lending environment will develop with different base rates supporting products with a variety of pricing, risk and return characteristics. This is a profound change that requires investment and client education
KEY TAKEAWAYS
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EXPECTED RATES AND TIMEFRAMES: OLIVER WYMAN’S VIEW
End of USD LIBOR IssuanceARRC Best Practice
Q1–2021 Q2–2022Q1–2022Q4–2021Q3–2021Q2–2021
Term SOFR Published -OW Estimate: Q1-Q2 2022
In-Arrears SOFR Available for Lending
Lending Moves to Term SOFR and/or a CSR
CSR Lending Begins?
LIBOR Lending ContinuesLIBOR Lending
CSRs Continue Development
Term SOFR Begins Publishing
Commercial lending moves to in-arrears SOFR unless Term SOFR or a CSR available
Commercial lending moves to Term SOFR and or a CSR when available
Valley of Uncertainty
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Survey Findings Considerations
1There is a widespread belief SOFR lending is small given structural issues, including with the in-arrears rate
• Issues cited included:– Lack of term/interest rate certainty for each lending period– Reaction in stress conditions– Unrelated to funding costs– Implementation and operational readiness– Depth of the SOFR swap market, a “chicken and egg” issue
2 Lenders and borrowers are keenly waiting for Term SOFR
• Widespread interest in a term rate• Little interest for in-advance SOFR despite its use in mortgages
3 Other factors are also contributing to the slow take-on
• Credit Sensitive Rates (CSR) under development, seen as potentially attractive alternatives
• Many do not want to offer both LIBOR and SOFR loans simultaneously
4 There is little customer demand • Almost no sign of customers who ask for SOFR
5 Most lenders indicate they are “fast followers” and are waiting
• Over two-thirds of participants said they want to be “fast followers” waiting for large lenders and syndicate leaders to define forward market
THE STRUCTURAL ISSUES WITH SOFR AS A LENDING RATE ARE SIGNIFICANT AND THIS HAS HAD DIRECT IMPACT ON SOFR ADOPTION
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WHILE THERE IS BROAD AGREEMENT ON THE “WISH LIST”, NONE OF THE AVAILABLE RATES EXHIBIT THE CHARACTERISTICS NEEDED TO DOMINATEDesired characteristics according to survey participants’ conviction
Credit sensitive
This is likely to lead to a multi-rate environment unless a rate emerges that incorporates all(or nearly all) of these features
Standardized
Accounts for cost of funding
Simple, understandable rate
Accepted by the market and regulators
Accounts for tenors
Interest rate transparency and visibility
Viable hedging capabilities
Similar economics to LIBOR
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• Before the extension of LIBOR to June 2023 most thought Term SOFR would be available by end of 2021 and be the primary lending rate
• This seems less likely, and we believe production of Term SOFR is likely to slip into 2022– With LIBOR available until 2023 we believe it will be dominant for lending in 2021– With more LIBOR lending there will be less SOFR lending and less SOFR hedging… – … Likely delaying publication of Term SOFR
• Any delay in Term SOFR provides more time for CSRs to develop and gain use – also draining SOFR lending
• The below chart shows swap volumes by currency broken down into LIBOR and its alternative. Notably SOFR swap volume was miniscule in 2020.
ADDING TO THE CONFUSION IS CONCERN OVER WHEN TERM SOFR WILL BE AVAILABLE
0%
40%
20%
80%
60%
100%
SwitzUKUS EU Japan
LIBOR rateWG rate
2020 ISDA swap volume %, LIBOR and WG Rates
Chart Courtesy of George M. Bollenbacher, 2021
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WHICH LENDING RATE WILL DOMINATE: THE RACE IS ON!
The banking system can support multiple base rates (flexibility is additive), but to be successful any rate requires a fully developed ecosystem
• Key attributes of a successful reference rate are clear
• A Credit Sensitive Rate (CSR) is desired by many, but is not mandatory– Most lenders feel they can price loans from a risk-free rate – Many viewed a CSR as likely to dominate lending: “.. With 30% of the balance
sheet on LIBOR, the risk is large without a credit spread”– Lenders are also supportive of using a CSR as an add on to SOFR
• The (Term) SOFR versus CSR race will be won or lost in 2021– Either a rate will emerge, or the concept will fail– We believe one or more CSRs will emerge to challenge Term SOFR
• Longer term we view a multi-base-rate environment as likely– There is value in the market having base rates with different characteristics. While
more complex, this supports richer options and a better match of risk and return– Testing multiple rates will enable the strengths and weaknesses of different
options to be understood and potentially mitigated– Borrower concerns will strongly factor into this!
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LENDERS HAVE ENGAGED BORROWERS, BUT FOCUS ON BASE RATE CHANGE IS LOW
Survey Findings Considerations
1 Systematic client engagement seems to be the norm among lenders
• A majority of lenders have heavily invested in client education • Client reaction varies by cohort but was low overall• Many borrowers are “in wait and see mode” and “expect LIBOR to get
extended”
2Borrowers have a clear preference for the LIBOR replacement – it should operate like LIBOR!
• Many borrowers indicate they will focus on “all-in” economics and do not think in terms of a risk-free base rate and a spread
• Many view in-arrears SOFR poorly as they want payment certainty or have technical environments that are not ready
• Some borrowers are willing to use a multi-rate environment but expect meaningful differences in pricing. For example, a loan incorporating a credit spread would be visibly less expensive during normal market conditions.
3Borrowers are likely to demand their cost to be the lower of SOFR+spread and LIBOR+spread while the two rates are available
• New to the market is a period when LIBOR and SOFR are both published; without education borrowers may not understand why there will be “all-in” differences in their cost
• This may in effect set a ceiling on pricing – the lower of LIBOR+spread vs. SOFR+spread
4 Lenders doubt borrowers can use in-arrears SOFR
• Borrower treasury systems are lagging industry development of in-arrears capabilities
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BORROWERS’ TOP CONCERNS ARE SIMILAR TO THE LENDERS
*Denotes concern for both borrowers and lenders
Higher PricingConcerns*
Lack ofTransparency /
Understanding ofNew Rate*
Lack of Term Rate* OperationalReadiness
Hedging Ability *
Incr
easin
g M
entio
n
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Borrowers simply do not care a great deal about transition and as a result are unlikely to accept moving off LIBOR until its end is near
• Borrowers are clear about what they want in the transition:– Similar economics to LIBOR-based borrowing, similar interest expense– Operationally straightforward – Ability to accrue interest expense in advance– Interest rate certainty, clarity around conventions, and readily hedgeable
• Borrower priority is the actual payment, not the details. When asked:– Uniformly reject the idea of a credit spread– Uniformly reject the idea of paying for the absence of a credit spread– Yes, this is contradictory ‒ borrower education will be a critical journey!
• Lenders will have a significant management challenge when LIBOR and SOFR are visible in the market at the same time as borrowers
• As we believe a multi-rate environment will emerge there will need to be discussion and education for borrowers to understand and accept this, as well as clearly differentiated use cases and pricing
BORROWERS ARE DISINTERESTED, AMPLIFYING THE UNCERTAINTY
AdamSchneiderPartner, Head of LIBOR [email protected]
FALLBACKS AND THEIR ROLE IN ESTABLISHING THE FUTURE MARKET
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LENDERS ARE CONCERNED ABOUT FALLBACKS INFLUENCING THE PRICING OF THE FUTURE LENDING MARKET
Survey Findings Considerations
1We did not expect fallbacks to influence go-forward loan pricing – but found they are significant as “the only game”
• In many cases a client’s first exposure to SOFR is through discussions about existing positions and their fallback after LIBOR
• ARRC has defined fallbacks based on SOFR. When borrowers think about SOFR loans they tend to use ARRC fallbacks as a pricing guide.
• Lenders are concerned they will have to justify why the pricing of new SOFR loans differs from the fallback historical average.
2 Fallbacks have major issues now that execution is postponed until Q3 2023
• USD fallbacks will execute from July 2023 but are being locked in now• Many lenders reported they would not today issue a SOFR loan for fall 2023
using the ARRC spread… but ARRC fallbacks have the same economics.• ARRC fallbacks do not allow for market change in the time before use and
lenders were concerned a CSR may become standard.
3 Regulatory guidance is creating further discomfort
• Many lenders are reading recent regulatory guidance as “use a hard-wired fallback” while at the same time there have concerns about them given there is not a CSR in the waterfall
4 The discrepancy between lending fallbacks and hedges are concerning
• This is likely to be widespread as the preferred loan fallback is Term SOFR but the standard swap fallback is overnight in-arrears SOFR.
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Our Take• Lenders had been planning on more or less simultaneous events: the end
of LIBOR/fallbacks/new ARR lending. The extension of LIBOR’s availability to June 30, 2023 has multiple impacts
• For lending: The economics of fallbacks are likely to influence go-forward loan pricing since they will overlap. Lenders will need an education campaign for borrowers to understand the difference
• For fallbacks: The current standard waterfall is static, but fallbacks now execute in the last half of 2023. This is similar to committing now to loan pricing in the future. We recommend lenders evaluate fallback plans and either continue using the amendment approach or use a hard-wired fallback that supports market evolution towards a CSR
• While borrowers are concerned about loan and hedge fallbacks, we did not find any lender with a program to address this
LENDERS ARE CONCERNED ABOUT THE ROLE OF FALLBACKS IN ESTABLISHING THE FUTURE MARKETJust as firms were moving towards hardwired fallbacks, the LIBOR extension to June 30, 2023 brings issues with their use
AdamSchneiderPartner, Head of LIBOR [email protected]
WHERE DO WE GO FROM HERE?
6PrernaGuptaLead Consultant, Lending [email protected]
UmitKayaPartner, Risk and [email protected]
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KEY TAKEAWAYS (REDUX)
2021 will be the defining year
The choice of post-LIBOR base rate is unclear and further development is compulsory
A “valley of uncertainty” is likely at the end of 2021 is development is incomplete and a winner does not emerge
There is a risk of NIM compression while both LIBOR and SOFR are in the market
Fallbacks need to be re-examined to avoid substantial mispricing due to hard-wired fallbacks
We believe a multi-rate lending environment will likely develop, requiring substantial investment and education
