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.

Visit us at mayerbrown.com

Mayer Brown is a global legal services provider comprising legal practices that are separate entities (the "Mayer Brown Practices"). The Mayer Brown Practices are: Mayer Brown LLP and Mayer Brown Europe - Brussels LLP, both limited liability partnerships established in Illinois USA; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales (authorized and regulated by the Solicitors Regulation Authority and registered in England and Wales number OC 303359); Mayer Brown, a SELAS established in France; Mayer Brown JSM, a Hong Kong partnership and its associated entities in Asia; and Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. "Mayer Brown" and the Mayer Brown logo are the trademarks of the Mayer Brown Practices in their respective jurisdictions.

© Copyright 2020. The Mayer Brown Practices. All rights reserved.

This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.