Pub. 10 2019 Issue 2

Summer 2019 17 West Virginia Banker So, what is SOFR? SOFR is a broad-based measure of the cost of borrowing cash overnight, collateralized by Treasury securities . As SOFR is a secured rate comprised of essen- tially “risk-free” funding, it will tend to be lower in rate versus LIBOR, which reflects interbank funding credit risk in its rate. At SOFR’s launch, the launch rate was 8 basis points lower vs. 1-month LIBOR and 12 basis points higher vs. overnight U.S. Fed Funds. SOFR Compared to LIBOR As a secured rate, during periods of credit stress, SOFR may not exhibit the wild rate swings observed with LIBOR. This absence of a credit risk element will therefore have to be tak- en into account when benchmarking to SOFR. On balance, SOFR should track well with the general direction of interest rates, as it is highly correlated to existing LIBOR and Fed Funds benchmarks. Dennis Falk SVP, Regional Manager Phone: 804-356-2048 dfalk@pcbb.com pcbb.com Dedicated to serving the needs of community banks, PCBB’s comprehensive and robust set of solutions includes: cash management, international services, lending solutions and risk management advisory services, including CECL FITTM. The Estimated Timeline for SOFR Given the enormity of existing transactions tied to LIBOR (over $200 trillion in the interest rate swap market alone), the transition from LIBOR to SOFR is expected to be carefully implemented, including key milestones, before widespread adoption. As such, it’s important to follow the progress and make the necessary adjustments. The Expected Transitional Impact Due to the difference in calculation and sources between SOFR and LIBOR, credit spread adjustments will be neces- sary to maintain the stability of transaction economics. In determining the necessary credit spread adjustment, it is very important to ensure consistency of the existing economics. The adjustment can be determined from a historical mean/ median of the SOFR vs LIBOR index spread, or from the basis difference in fair values using the respective SOFR and LIBOR yield curves at transition. Key Steps Community Banks Can Take The good news for bankers is that we still have a few years before a full-fledged transition. Yet, there are some potential challenges you may need to address. • Watch for higher levels of contract variation and adjust your contracts, especially new commercial loans, accord- ing to the appropriate index. • Address borrowers’ concerns over the loss of visibility into their cash flows with this change. • Fine-tune pricing, terms and disclosures for any new LIBOR-linked lending over a period of time. • Perform periodic assessments of economic impacts and spread adjustments necessary to preserve transaction economics. • Track the SOFR vs. LIBOR relationship as you manage your existing loans and underwrite new transactions. Even if the transition to SOFR doesn’t need to be complet- ed until 2021, steps need to be taken long before then to ensure the integrity of your loan portfolios. Transitioning from LIBOR to SOFR does not need to be difficult. Yet, it is important to understand the nuances involved. If you find you need additional assistance, we are here to help; PCBB has been providing hedging expertise to community banks for over 15 years.  i Composed of tri-party repo, General Collateral Finance (GCF) repo and bilateral Treasury repo cleared through the Fixed Income Clearing Corporation (FICC)