Regulators, standard setters, financial institutions, and other industry participants around the world have been working on replacing the London Interbank Offered Rate (Libor) for several years. By the end of 2021, Libor is expected to be out and a new reference rate will be in. At first hearing, that sounds like bank reform at a macro level, and as a CFO of a small to medium enterprise, or a manufacturing company in the Midwest, maybe you think this isn’t really your problem. Guess again.
Replacing Libor extends to pretty much every company that has rate referenced debt or contracts, assets, hedges, or accounting systems — basically everyone. Even the average consumer will not be spared. Credit cards, car loans, student loans, and adjustable-rate mortgages that reference Libor will all be affected.
Why Stir the Pot?
Libor is defined as the average interest rate used when major global banks borrow from one another in the international interbank market for short-term loans. The trouble, however, is that interbank loan volumes have been falling for years. Libor is based on the opinion of between 11 and 16 privately held banks, as opposed to widely observable market transactions. On a typical day, for example, the volume of three-month funding transactions between banks is about $500 million, often a lot lower. That compares with almost $400 trillion of global financial contracts that reference Libor.
Randal Quarles, vice chairman for supervision at the New York Federal Reserve noted how thin the market is: “We observe six or seven transactions per day at market rates that could underpin one- and three-month Libor across all of the panel banks. The longer maturities have even fewer transactions…. On average, there is only one transaction [per day] that we see underlying one-year Libor, and many days there are no transactions at all.”
Libor has also been associated with corporate malfeasance. It was at the core of the 2012 banking scandal in which some banks were found to have manipulated the rate to their own ends.
In the United States, the Alternative Reference Rates Committee, convened by the Fed, has identified the Secured Overnight Financing Rate (SOFR) as its preferred alternative to U.S. dollar Libor. However, SOFR is a recommended rate, not a required rate. That means contract counterparties may choose to replace Libor with a different rate.
SOFR, based on U.S. Treasury repo transactions (repurchase agreements), provides a broad measure of the cost of financing U.S. Treasury securities overnight. Federal Reserve chairman Jerome Powell and chairman of the U.S. Commodity Futures Trading Commission Christopher Giancarlo have noted that SOFR “resolves the central problem with Libor, because it will be based on actual market transactions currently reflecting roughly $800 billion in daily activity.”
Each business day, the New York Fed publishes the SOFR on its website at about 8 a.m. One-year Libor as of August 12, 2019, was 2.12%, whereas SOFR was 2.11%.
With the expected drop-dead date for replacing Libor in 2021, the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) are promoting awareness of, and helping provide relief for, this important market transition. As FASB has noted, “There are trillions of dollars in loans, derivatives, and other financial contracts that reference LIBOR, and consequently, the related cash flows are tied to that rate…. This will be a major undertaking for not just banks, but for anyone with loans or debt on their books.”
One of the problems created in transitioning to an alternative reference rate is related to the adjustment of loan terms. When loan terms change, both the loan originator and the borrower are required under Generally Accepted Accounting Principles (GAAP) to perform tests to determine if the loan is considered a modified loan or a new loan. This quantitative test must be performed for each loan modified.
For example, the “10% test” states that if the present value of future cash flows under the modified loan is less than 10% different from the present value of future cash flows under the old loan, the new loan is considered a continuation of the old loan rather than the establishment of a new loan for accounting purposes. In that situation, no gain or loss would be recorded because the modified loan would not be fair valued upon modification.
Consequently, as pointed out by the Loan Syndications and Trading Association, transitioning to Libor “could lead to a significant amount of work, and possibly financial statement volatility as well, depending on how many loans have to be recorded at fair value.” And apparently, that number is large. In the United States there are about $36 trillion in notional loans outstanding that will not mature before Libor is set to end. And that assumes there are no new Libor-based issuances, says the New York Fed. There are still new loan agreements being entered into using Libor, but there is no way of knowing how many.
Similar difficulties arise with interest-rate hedging. As noted in KPMG’s recent examination of the issue, under both U.S. GAAP and International Financial Reporting Standards, if a hedge’s underlying reference rate is changed, “entities need to evaluate whether such a change would be considered a termination of the hedging instrument, resulting in a need to de-designate the hedging relationship, which may result in unexpected income statement volatility going forward.”
The end of Libor will have wider implications as well. “Potentially affected contracts are not limited to financial instruments and credit agreements but also may include other commercial contracts, such as contracts with customers, vendors, and employees,” according to an SEC July staff statement.
Experts such as Ming Min Lee, principal, financial services, for Oliver Wyman, point out that the more indirect areas of impact that CFOs need to consider include late payment fees and software systems. For example, on oil and gas contracts with a late delivery or late payment fee, the penalty rate is based on Libor.
In addition, “accounting rules typically have Libor as an input,” says Lee, and many systems have Libor as a data feed.
Audit firms have been giving their clients the heads up for some time. Moving from Libor to SOFR “could have a cascading affect beyond contract terms into the operations and financial reports of thousands of institutions,” according to KPMG. “Organizations that don’t act now may face increasing costs and resource needs to manage the transition in the coming years.”
Easing the Pain
FASB knows there will be a significant amount of work involved in transitioning from Libor to an alternative reference rate. On July 17, it agreed to move forward with optional accounting relief to reduce the cost and complexity associated with accounting for contracts and hedging relationships affected by reference rate reform.
The proposal would simplify the accounting evaluation of a contract modification. If certain criteria are met, changing the reference rate from Libor would count as a continuation of a contract rather than a new contract. The change to hedge accounting would simplify the assessment of hedge effectiveness and allow hedging relationships affected by reference rate reform to continue. FASB expects to release an exposure draft on the topic this September.
“Ultimately our project is about reducing cost and complexity so that the accounting rules do not impede this market-wide transition,” said Alex Casas, assistant director of research and technical activities at FASB.