Marco Macchiavelli, Professor of Finance
University of Massachusetts Amherst, Isenberg School of Management
Executive Summary.
- Since the planned retirement of LIBOR, market participants have coalesced around the Secured Overnight Financing Rate (SOFR) as the new reference rate;
- As discussed in Section 2, SOFR is a secured overnight rate which does not capture the funding risk of commercial banks and the effective fed funds rate (EFFR) reflects artificial market segmentation and arbitrage trades instead of bank funding costs;
- Banks issuing loans indexed to SOFR can experience negative interest margins in times of stress, when bank funding costs increase but secured rates remain stable or even decline. This indeed happened during the Covid-19 crisis of March 2020;
- We show in Section 4 that AMERIBOR, a credit-sensitive reference rate, is much more correlated with LIBOR than both SOFR and EFFR, and especially so during periods of stress;
- Thus, banks should index their loans to AMERIBOR to better manage interest rate risk and maintain stable and positive net interest margins.