Speaker 1:
As a bank that focuses on business, we work with business leaders all day, every day. We have a front row seat to what's working and what has potential. The First Business Bank Podcast is dedicated to sharing insights to help you work better, smarter and faster to achieve your goals. Let's get into the show.
Mark Meloy:
Hello, I'm Mark Meloy, CEO of First Business Bank. I'd like to welcome you to another episode of the First Business Bank Podcast. Today, we have an update regarding the imminent elimination of LIBOR as a base rate and what that means for borrowers and banks. About 10 months ago, we provided our initial podcast conversation on this topic and it was well received. However, as you would expect with time that has passed, more information and clarity has occurred. We did talk about a few proactive efforts about which First Business Bank bankers will be talking to clients. Those efforts are now complete. We'll update you with that and we'll talk about what clients should expect as we go forward. I'm joined today by two colleagues. We're going to introduce themselves and we'll get our conversation started. Ed, we'll start with you.
Ed Sloane:
Yes, Ed Sloane. I'm the CFO of First Business Bank. I've been with the company for about six years and very much involved in this LIBOR transition, really starting back to three years ago.
Mark Meloy:
Thanks, Ed. Bill?
Bill Uelmen:
Yeah, Bill Uelmen. I'm President of our Bank Consulting Group. I've been with the bank going back to 2016 and have been part of LIBOR Transition Group since we put that group together about three years ago.
Mark Meloy:
Thanks. Ed, I'm going to start with you. Bring us up to date on the current developments, as it relates to the transition away from LIBOR.
Ed Sloane:
Sure, Mark. Thank you. Yeah, there's been a few key changes made since we met last... First of all, I think the SOFR Index is kind of front and center to us. SOFR stands for... is the Secured Overnight Financing Rate. It is what we would consider to be a replacement index of choice. This has been something that's been developing in the market over the past, let's say year or so. It's a relatively new index and one that is endorsed by the regulators. So, we think that's an important component of this. There are some other indexes out there that... [BSBY 00:02:36], [Ameribor 00:02:36] are two examples that don't have the same type of endorsement or following behind them. We think ultimately SOFR is the one that'll win out for most banks. A couple other things to note with regard to current developments' year end 2021 is a key date in the transition.
Ed Sloane:
No new LIBOR contracts will be permitted after year end. A very important cutoff date. That doesn't mean that you wait until year end to make any sort of switch to a new replacement rate. As a matter of fact, loans that are in process today should be priced essentially at the replacement rate. We are actually looking at a couple here at the bank in the month of November to price under the new SOFR Index. So, I think it's an important point to make on a go forward that you really start now and get your feet wet with a new index because, again the year end cutoff date is a critical date. It's one that the regulators will monitor and follow relative to their next examinations. The other key date Mark that I would say is that LIBOR will no longer be published after June 30th of 2023.
Ed Sloane:
So, our stance on that is any existing contracts will require a new index prior to 2023. So, break that down for a moment. Any contracts that are maturing prior to that date and that are subject to renewal, obviously will need to be replaced with SOFR Index or a replacement index. But, the next question is what about loans that are maturing after that June 30th date where LIBOR ceases to exist? Well again, we kind of look at that here at the company as one that we want to be proactive with. So, if you do have something maturing after LIBOR cessation, we're going to reach out to our clients and make sure that we're working them through the next steps. Providing the education that they need and getting them in a position where we move to a replacement index. What we don't want is a fire drill after June 30th. Our mantra has been and always will be that we're going to be transparent and proactive with our clients as best we can.
Mark Meloy:
Good. So, just a quick point of clarity. As a borrower, as a LIBOR borrower that has maturity after December 31, 2021, they don't have to do anything? We've either got conversion language in it already. They've got a maturity date that's coming up prior to that June 30th, 2023 date, or one of two things. So, the next step really is on the bank. They don't have to do anything. Is that a fair statement?
Ed Sloane:
Yeah, I think that's absolutely correct. I would say we go back three years when we started to add replacement language, fallback language, as it's also referred to, into the existing LIBOR-based contracts. So, it gives us that ability and the flexibility to work with the client. And then, determine what that replacement rate would be. And then, make that switch.
Mark Meloy:
Yeah, that's a good point, Ed. Maybe describe how First Business Bank has prepared so far for this transition. There's been a lot of work that's been done already today.
Ed Sloane:
Yeah, yeah. As you and I both mentioned Mark, we go back a few years on this. Where we started to work with our attorneys to go in and modify contracts to have replacement or fallback language in it. That language basically, indicates that when that time comes to make a change in the index, that we essentially... The bank will look to what a new index looks like and make sure that they have that conversation with the client. So, that was involved and it took a couple years to really get those contracts to where they needed to be. And then beyond that, and Bill, I think you mentioned this transition team has been put together over that three-year time period to where it's a real good cross section. We have myself and Bill on the finance side, Mark on the client-facing side and a couple other folks that are involved from a client-facing standpoint.
Ed Sloane:
So, a good cross section on the transition team to make sure we're thinking about this in terms of what our pricing and an appropriate index would look like relative to LIBOR. But also, how it impacts the client and how we need to talk to the client about it. So, that was important to have that type of a transition group together. Beyond that, it's been really just spending the time, understanding what the appropriate indexes look like, where the regulators stand, as I mentioned earlier and making sure that we're endorsing the appropriate index.
Ed Sloane:
I will say this, there's a lot of inconsistencies that are out in the market. The indexes have been slowed to develop. When we spend our time reaching out to clients and competitors, other industry experts, it's really a mixed bag of rates and approaches that are out there. So, there's work to be done. This transition isn't over at December 31st. It's going to continue on for a period of time until we get consistency, more of a foothold in the industry as to what the appropriate indexes need to be.
Mark Meloy:
Yeah, thanks. Thanks.
Ed Sloane:
Mm-hmm (affirmative).
Mark Meloy:
That's really a great, great point. Bill, you've been waist deep, if not neck deep in this whole process since the very beginning. Talk about some of the obstacles that have been dealt with in this whole planning process.
Bill Uelmen:
Sure. I guess over this last year, it's been a challenge. The market really has been slow to develop a key index that's going to be the replacement for LIBOR. Ed touched down there's a BSBY rate, which is the Bloomberg Short Term Bank Yield rate, Ameribor, Prime, SOFR... There's really four different SOFR rates that have been thrown out there. The compounded SOFR, average SOFR, daily simple SOFR, term SOFR. So, there's been a lot of confusion in the market of which index is going to replace LIBOR and been looking for guidance from larger banks, derivative counter parties, regulators to point us in a certain direction. One of the challenges we face is that currently most contracts are being written off LIBOR still, probably will be through the end of the year. So, we haven't seen any one of the indexes take over as a replacement yet for LIBOR.
Bill Uelmen:
Now, regulators have pretty soundly endorsed SOFR as the replacement index. In fact, kind of indirectly criticized some of the other indexes without actually stating their names. Just really trying to get the market to focus on SOFR. A big change happen middle part of this year is that the regulators entrusted the CME Group to create the term 'SOFR Market'. That was really a big change. Our focus was on that to identify that SOFR was likely going to be the leading index. So, they created the one-month, three-month and six-month SOFR rate is now published on their website daily, published on other sources such as Bloomberg. So, we're starting to get more comfortable with choosing the SOFR rate, which we were doing.
Mark Meloy:
Yeah. Thanks, Bill. That's a really good summary of things. I know we talked about this last time, too. This is a big deal in the banking industry. We as an industry, it used to be prime rate. I'm going decades ago. And then, there was this transition to LIBOR because the market really wanted... As the market and information became more sophisticated, wanted a market driven rate, as opposed to what is often referred to as a managed rate. Yet, Prime has continued to exist. It will continue to exist going forward as well, because for some borrowers, it is the right way to do business. That's what they are most comfortable with.
Mark Meloy:
With the emergence of some of these newer base rates, I think the uncertainty that marketplace may present some caution. But, I like where we are and where we're headed as it relates to SOFR. It's not a perfect corollary, but it is I think the best of the possible alternatives that we have right now. So, Ed let's talk about how we are talking to our clients about this and maybe... We've touched on a little bit, but why SOFR? And then, let's talk about how it does correlate to the best possible way with LIBOR. Can you help us out there?
Ed Sloane:
Yeah. So, why SOFR? It is because it is highly correlated to the LIBOR Index. Bill, I won't go in too deep on this. You can talk a little bit about some of the differences between them. But, we do see it as an appropriate. You mentioned before Mark that this is strongly endorsed by the regulators. That's a key point. There is some differences between SOFR being a secure rate and LIBOR being unsecured. So, there's a credit spread differential between those. Again, Bill will talk about that a little bit more. But, I think because it is so strong in its backing by the regulators. The fact that it's been published and out there for some time. The fact that any spread differential between it and LIBOR is published, as well. I think those are key points that will need to provide to our clients through some additional education around it.
Ed Sloane:
So, correlation is a big part of it and we'll address it. But you know, also what we're hearing from our competitors, our correspondent banks, our industry experts and all the things that we've been addressing for some time, we think that there's obviously a mixed bag of approaches to this. But, SOFR because of it being so visible and published, it continues to be kind of the front runner on it. I think we get out a year from now, I'm not sure what it all looks like. So, all we can do is work with what we know, what our competitors are doing. Make sure that we kind of align with what's going on in the industry and remain flexible as things continue to develop. That's what we'll share with our client base.
Mark Meloy:
Okay, good. Thanks. Bill, can you share with us a little bit about that correlation between LIBOR and SOFR? What the client should expect to see in this regard?
Bill Uelmen:
Sure, sure. You touched on this, Ed. There's a very strong correlation between these all the indexes we're talking about, but really between the LIBOR and SOFR. We'll publish a chart that you can download from our website. You'll show the historical correlation between the two. There was a significant difference between the indexes when we got into 2020. When the Federal Reserve dropped interest rates unexpectedly down to zero because of the pandemic. It took a little while for the credit component that's built into LIBOR to get back to SOFR. So, LIBOR is quite a bit higher than SOFR for that period, but eventually the trend line came very close to each other. One of the key elements here is that LIBOR is an unsecured rate and SOFR is a secured rate. So, what that means there's a credit component built into LIBOR.
Bill Uelmen:
If you think about LIBOR, think there is a risk-free rate in LIBOR plus a credit spread built right into the index. That spread will vary over time. It can be five to 20 basis points in that index spread. SOFR is secured. So, it's all the average of the daily, overnight repo transactions, which are secured by the US Government bonds. So, considered to be risk free. There's a spread differential on that. The Federal Reserve Bank in New York calculated the average difference and published this rate that we can use essentially to make LIBOR and SOFR equal to each other.
Bill Uelmen:
That calculation was exactly 11.448 basis points. They went down to three decimals on the average. And so, when we look at the difference, we have to add that 11.448 basis points to SOFR to equal LIBOR. We do feel that the spread differential will change over time. There's going to be some, as I mentioned, that credit spread built into LIBOR will adjust. We do expect the Fed to likely change that spread differential. But again, we're always going to be using whatever the Fed references and publishes essentially. For example, today if we calculated the number Bloomberg has an estimate, what the number would be, it's closer to 16 basis points. But, we're going to stick with whatever the Fed publishes essentially for the spread differential.
Mark Meloy:
Yeah, I think that's a good point. I think that's a key point here, as we're talking about this in terms of what the impact is on our clients, our borrowers. What is intended here is to change the index, but not to over the long run change the rate impact on the client. There may be basis points, even in the very beginning, there may be basis points differences. But to your point, the Federal Reserve Bank of New York has looked at this over a lengthy time horizon at least five years and made this correlation. So, Bill what's the net impact on how this affects the client borrower?
Bill Uelmen:
So, really it should have no impact to the client. The spread relationship will change over time, as we talked about. But if over the term of the loan, the net interest cost should be very close to exactly what it would be if we just use LIBOR. That's what we're trying to get to, or the Fed Reserve is trying to get to with this 11 plus basis points is just to make sure we build in that credit component into SOFR.
Mark Meloy:
So, how might that present itself to the client in their note?
Bill Uelmen:
Yeah, so what we would do is we'll have the typical credit spread, let's say the credit spread is 250 basis points. We'll have a spread adjustment. So, another increase of the 11.448 basis points plus the SOFR Index. So, there'll be three components to that index, to the rate, to get to that net rate, essentially.
Mark Meloy:
As opposed to under LIBOR, it might be LIBOR plus the 250 kind of thing. It'll...
Bill Uelmen:
Exactly.
Mark Meloy:
It'll look somewhat different, if you will... Plus 250 with LIBOR is equivalent to SOFR plus 261.
Bill Uelmen:
Exactly and some banks may price it that way. Some may say, increase the credit spread to 261. Our intent is really to have the three components of that rate in the note.
Mark Meloy:
I think that's an important point. I think this is one of those things in terms of the public, the client borrower public thinking about this is kind of to gain that clarity, especially if you're accepting proposals from competing banks. To have a clear understanding of what is being presented to you by all the banks, each bank. So as we wind up here, guys let's talk about the kind of top four or five things that we should take away from this conversation today. Bill, I'll start with you on this.
Bill Uelmen:
Sure. Well, the key one is that First Business Bank, we are choosing SOFR as the replacement index. So, we'll be trending towards SOFR. We're getting our systems in place everything we need to have to change to that new index. We'd like to get it done before the end of the year to test it. But again, at the beginning of next year, it will be SOFR. As you mentioned, LIBOR is not going away until June 30th of 2023. So, existing LIBOR loans will continue to be index to LIBOR through that date. So, let's just keep that in mind.
Ed Sloane:
Yeah. Just to take off of what Bill was referring to, I think the key dates are very important. Just to reiterate again at year end, what's going to happen. LIBOR on new contracts, no longer permitted. Mark, you mentioned this earlier that we have replacement index language in place. So, for those loans that are maturing and renewing after that date, we'll have those discussions proactively with our clients as to the action that needs to be taken, the next steps associated with that. And then, when LIBOR ceases to exist at June 30th of 23, we got a good 19 months before we get to that point. Again, we'll be reaching out to our clients that have loans maturing after that timeframe to make sure that we convert that index to a replacement index, likely SOFR at that point.
Ed Sloane:
So, those are a couple of the key dates to keep in mind. I think the only other thing that I would say is just, again, follow up with couple things that Bill mentioned earlier, that index spread and how that gets handled that 11.448 basis points. We need to keep in mind that when looking at competitors on pricing, there could be a... And I've used this term before a mixed bag of how it is calculated. Again, we're focused on what's being published so that we have clear support for the approach that we're taking. But, there is variations to that in the market and that'll probably continue to evolve as we move forward.
Ed Sloane:
The final note that I would add is on the regulatory side of it. I think it's important that we continue to pay attention to guidance coming from the regulators. We mentioned the endorsement to SOFR from them, but then also other observations that they have. They're a really good conduit for us to think about this in the market. They have good feedback coming from all of their banks and provide that guidance to us. I think it is going to be real important. So, we'll continue to monitor this from a regulatory standpoint.
Mark Meloy:
Yeah, thanks. Those are all great comments. Just to add to everything that's been said and inherent in the comments that both of you made is that really as a client, as a borrower seek transparency... If you don't understand, if you don't think you're comfortable, ask the questions. We've spent a lot of time on this. Our client relationship, our client facing teams have sat through and listened to us talk about this on multiple occasions. We're outfitting them with lots of good information. We'll post more information on our website in terms of Frequently Asked Questions presentation. Of course, you've got this podcast and other things that we've made available. So, it's really the best advice I can have is don't allow yourself to be in the dark or confused.
Mark Meloy:
If you don't understand, ask the questions. We want to proactively address as much of it as we can with our clients. But, we know that people absorb this information and you hear other things from suppliers or customers or other people in the marketplace talking about this transition and how it might affect them. You're going to hear competing kind of that mixed bag if you will, again, that we've talked about that in terms of the different indices that are going to be out there. Where we're headed, I think is well thought out. I think it's the fairest and the best way to make this transition with our clients in fairness to them. It makes sense in the interest rate swap market. So, I think we're in a good spot and we want our clients to be comfortable with that, as well.
Mark Meloy:
Thanks guys. I want to thank you for taking the time to share your experiences, your thoughts on this. I think this is a really important topic. We haven't really faced something exactly like this in the banking industry before. It's a time of transition, but I think a good one. To our audience, thanks for listening in our conversation. As we move closer on the calendar to the eventual elimination of LIBOR, you'll continue to hear more and more about this from our First Business Bank team. As I said before, if you don't understand, if you feel confused, please reach out to us. Ask the questions that you need to ask and we'll provide the answers. Thanks for listening. Tune in next time on the First Business Bank Podcast.
Speaker 1:
If you want more content like what you just heard delivered straight to your inbox? Go to firstbusinessbankpodcast.com. If you haven't already, make sure to subscribe to the First Business Bank Podcast, wherever you listen to podcasts. If you're listening on Apple Podcasts, please leave a quick rating of the show. Thanks so much for listening. First Business Bank member FDIC.