Banks' rates transition may pinch margins in near term

Singapore

SINGAPORE banks may see some margin compression as the industry transitions to risk-free reference rates, but there is no race to the bottom for loan pricing in the next few years, said analysts.

Singapore is moving towards the Singapore Overnight Rate Average (Sora) as the main interest rate benchmark for the Singapore dollar (SGD) financial markets in the future, with the Swap Offer Rate (SOR) and the Singapore Interbank Offered Rate (Sibor) soon to be discontinued.

SOR - the current benchmark used to price derivatives and business loans here - will be the first to cease, given the eventual phasing out of the scandal-tainted Libor, which would affect SOR as it uses the USD Libor in its computation.

Sibor, a key reference rate in retail mortgages, will be discontinued by end-2024, in line with global efforts on interest rate benchmark reform.

Sora was selected as it was found to be the "most robust and suitable alternative", underpinned by a deep and liquid overnight funding market.

As backward-looking overnight rates, Sora is thought to offer more stability as it is based on actual market transactions.

Forward-looking term rates like SOR and Sibor are more exposed to market factors, such as quarter or year-end volatility and open to manipulation, as seen in the USD Libor where major global banks colluded to rig rates.

That is why Sora is also known as a risk-free rate, while SOR term rates carry both a credit risk and term risk premium.

With the Sora rate usually lower than both the Sibor and SOR, banks typically apply a spread when pricing Sora-referenced loans in their transition phase. For instance, on Feb 10, 2021, 3-month Sibor stood at 0.41, while SOR stood at 0.21. The 3-month compounded Sora rate was at 0.17.

Gary Chia, partner, financial services advisory, KPMG Singapore said that when Sora is used for customer loan pricing, the spread quoted over Sora would have to be higher than the original spread over SOR or Sibor to take the additional risk premiums into account.

This comes as the higher customer spread reflects the risk premiums associated with the term risk and the credit risk - components not embedded in the Sora rates.

"After taking into account the two risk premiums, the final absolute amount of interest payments on the loans, whether they were referencing SOR, Sibor or Sora, should work out to be about the same over the lifetime of the loan, should everything else, such as market conditions, remain the same," said Mr Chia.

He added that regardless of the transition to Sora, banks operating in an ultra-competitive environment will need to price their products well to attract customers, but it is "unlikely to lead to a price war".

Ivan Tan, analyst at S&P Global Ratings said that the transition to Sora will have "limited impact" on bank net interest margins.

"We don't see this as a 'race to the bottom' for banks," he said. Be it Sora- or SOR- or Sibor-based loans, banks will likely adjust the spread such that the effective interest rate will be "very similar" to the rates seen before the switch to Sora, he said.

The benchmark interest rate is just one component of loan pricing, he said. The full price of a loan is dependent on a number of factors, including the customer's credit profile, duration of the loan and the bank's funding costs - all of which will be adjusted for in the spread, Mr Tan added.

Willie Tanoto, director, banks - APAC, Fitch Ratings said that it is "not obvious" that Sora-linked loans should be priced lower or higher than loans based off other benchmarks.

In the current low interest rate environment with ample liquidity and scarce assets, low-risk borrowers may have some negotiating leverage and get lower borrowing rates, but it is not structural in the design of Sora, he said.

While spread compression is not an inevitable result of the migration to Sora, successful banks with superior market pricing power are usually able to conduct effective asset liability management on both sides of their balance sheets and limit net interest margin compression, he said. But this transition value is not necessarily transferred to borrowers.

Tay Wee Kuang, research analyst at Phillip Securities Research, said customers will still have preference for loan tenures, as it is still a trade-off between stability in interest rates against potential savings. "Customers will also be able to judge interest rate trends based on treasury yields."

There may be some margin compression as a result of shifting to Sora due to lower premium as compared to the "uncertainty premium" spread commanded by the forward-looking SOR or Sibor, he said.

But he pointed out that as the Sora system is still new to the market, the lower liquidity may help to stave off near-term compression.

Interest income will "remain as the bread-and-butter business" for banks, said Mr Tay. Even if banks face tighter margins, they will have the ability to manage this through their funding costs, he added.

"I do not think the banks will pivot towards non-interest income more than they have," he said. "Non-interest income will remain as the growth segment to a bank's income compared to the interest income, which is supposed to provide banks with a stable source of income."

Mr Tanoto said: "Growing non-interest income has long been a strategic objective of banks to diversify their revenue streams and this will likely continue."