medium · FRM Part 2 Current Issues
In the transition away from LIBOR, a key conceptual difference between LIBOR and SOFR is the credit-sensitivity component. A risk manager argues that during a systemic stress event, a bank funding floating-rate assets indexed to SOFR while its own funding costs spike will experience a specific basis risk that did NOT exist under LIBOR.
Which statement most precisely characterizes this risk and its second-order implication for the bank?
- Because SOFR is nearly risk-free and rises little (or falls) when bank credit spreads blow out, asset coupons fail to track the bank's own funding cost, widening the funding-cost-to-asset-yield gap exactly when stress peaks—an exposure LIBOR's embedded bank-credit premium had partially hedged
- SOFR compounds daily from overnight repo fixings with no forward-looking term structure the way LIBOR's panel-quoted rate had, so SOFR-linked asset coupons reprice with a lag versus the bank's own funding costs, generating a temporary favorable basis right as funding stress first builds.
- SOFR is collateralized by Treasury general-collateral repo, and this secured linkage raises its realized volatility above LIBOR's unsecured-panel volatility, causing SOFR coupons to overshoot the bank's rising funding costs in stress, creating a windfall examiners would require reserving against.
- SOFR is published only as an overnight fixing with no panel-based term quotations comparable to LIBOR, so banks are structurally forced to abandon term lending altogether, bearing an uncompensated duration mismatch crystallizing only once the yield curve inverts sharply amid systemic stress conditions.
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