Financial markets employ benchmark interest rates as critical reference points for pricing a wide array of financial products. These benchmarks and risk premiums ascribed to them are integral to the commercial lending processes. The most widely recognized benchmark is the Secured Overnight Financing Rate (SOFR), which gained prominence as an alternative to the London Interbank Offered Rate (LIBOR).
The primary difference between SOFR and LIBOR lies in their securities. LIBOR is an unsecured rate, representing the average interest rate at which major banks can borrow from each other. SOFR is secured, reflecting the cost of overnight borrowing using U.S. Treasury securities as collateral. This shift from unsecured to secured lending provides a more accurate benchmark, as it is based on actual transactions rather than estimated rates submitted by banks. Another widely accepted benchmark is the Wall Street Journal Prime rate (WSJ Prime). The WSJ Prime rate is also an unsecured rate, determined by surveying the 30 largest banks in the U.S. It is a consensus-based rate and represents the interest rate at which these banks are willing to lend to their most creditworthy customers. WSJ Prime is a longer-term rate and is typically more stable than overnight rates like SOFR, because it remains the same until the Wall Street Journal publishes an update based on the banks’ survey results. Although SOFR is the only index directly tied to the Federal Funds Rate, all three are influenced by changes and decisions the Federal Reserve makes.
Once a benchmark rate is established, a lender will adjust their own rates over (or under) the benchmark, called a “spread”. The spread is interest rate adjustment that financial institutions add to the benchmark rate to calculate the interest charged on loans. If the benchmark increases and spreads remain the same, the price of borrowing increases. Lender-provided spreads reflect the credit risk, liquidity risk, and market conditions at a given time for each transaction. Borrowers with a higher credit risk, such as small businesses, developers with little experience, net worth, or liquidity, or individuals with poor credit histories, are perceived as more likely to default on their loans. Consequently, lenders demand a higher spread (risk premium) above the benchmark rate to compensate for this increased risk. In contrast, borrowers with strong profiles receive loans at narrower spreads. Additionally, financial institutions operating in less liquid markets may face challenges when attempting to sell assets or raise funds. As a result, the spread above the benchmark rate might widen to reflect the increased difficulty and cost associated with obtaining funding. Economic conditions, inflation expectations, and overall market activity can also influence the spread above benchmark rates. During periods of economic uncertainty and lesser supply of capital, lenders may demand higher spreads, leading to an overall increase in borrowing costs. Alternatively, during times of economic growth and stability, spreads might narrow, making borrowing more affordable.
In conclusion, benchmark interest rates and spreads are vital, if somewhat basic, components of the financial markets. Spreads above benchmark rates reflect the ever-changing dynamics of credit and market risks, shaping the interest rate environment for borrowers and investors alike.
