Technical
Paul Golden 4 Apr 2019 01:33pm

Coming off the bench

Benchmark reform by global regulators will impact upon financial reporting in the next two years, and accountants need to be ready, reports Paul Golden

off the bench mag april 630
Caption: Illustration by Alice Mollon

The Financial Conduct Authority (FCA) has confirmed LIBOR will have limited support after 2021, but there are trillions of dollars of LIBOR-related transactions that will not mature until after that date. Firms with direct or derivative positions that reference LIBOR need to be thinking about the implications across all areas of their business.

Regulators globally have signalled that firms should transition away from benchmarks such as the London interbank offered rate, or LIBOR, to alternative rates. The FCA’s chief executive, Andrew Bailey, has stipulated that this should happen for LIBOR by the end of 2021. Benchmark reform will affect financial reporting in a variety of ways.

Key areas include hedge accounting and disclosure, with longer-term considerations focused on how to account for replacement of interbank offered rates when the changes take effect. In hedge accounting, companies should be considering how to meet the “highly probable” test for cashflow hedges, documentation of the hedged risk and hedge effectiveness testing.

Fair warning

Fair value measurement and leasing payments are also affected. Fair value could be affected both where the contractual terms of an instrument are expected to change to reflect an IBOR replacement rate and where IBOR-based discount rates are used as an input to fair value methodologies. In leasing, for any variable lease payments which are linked to an IBOR, IFRS 16 requires the discount rate and the lease liability to be updated when the cash flows change.

There are also a number of balance sheet line items that might be indirectly affected by IBOR replacement if they use an IBOR-based discount rate. The use of alternatives (and risk-free rates in particular) reflects a shift to using reference rates based on a deeper pool of transactional data, with less or no reliance on subjectivity but inherently more volatility, explains John Mongelard, technical manager, risk and regulation at ICAEW’s Financial Services Faculty.

“One of the biggest potential impacts is on hedge accounting,” he adds. “Interest rate swaps are based off of LIBOR, but what happens to the hedge effectiveness tests once LIBOR ceases?” The new rates may face challenges around whether there is adequate liquidity and market support for their usage, continues Mongelard.

“Loans, for example, are sometimes based off term rates which are currently not available – or have not yet been determined – under newer benchmark rates.” Preparers should understand how their processes work for these items to ensure they pick up any impact, notes PwC director Mark Randall. However, the effects of the move away from LIBOR are yet to be widely felt. Sangdeep Bakhshi, who advises corpo - rate clients on IBOR reform for EY, suggests it would be a surprise if any companies aside from the very largest corporations disclosed anything about LIBOR this year-end.

“At my presentation on LIBOR reform at our annual financial reporting conference, about three quarters of those in the room had not even heard of this issue,” says Bakhshi, who adds that some of the nervousness on the part of companies can be put down to the uncertainty around the move away from LIBOR.

Inventory important

“It is not realistic to expect them to start modelling and changing all their contracts, but they need to know what their inventory is and where this reform will impact the organisation,” he suggests. By way of example he says that we know derivatives are affected, “but LIBOR is also referenced in some commercial contracts so unless a company knows what its inventory is, it has no way of assessing the likely impact”.

PwC director Christopher Raftopou - los says most large corporates with significant exposure to LIBOR-based products are alert to the implications of a move away from this benchmark. For these businesses, the focus is on managing the possible accounting and operational consequences, securing near to medium-term funding and ensuring that no significant basis risk develops between their funding and derivative portfolios.

The honest assessment of Deloitte partner Mark Cankett is that no one is fully aware of all the implications from any part of the market. “There are ongoing initiatives to raise aware - ness, with various publications and activities from both the public and private sectors (such as the client communications and customer outreach sub-group of the Bank of England, trade associations, sell-side firms and consultancies) providing information on the key considerations for firms,” he says.

He warns that corporates should not rely on their banks to educate them on the impacts of LIBOR transition and they must take a lead on this issue. “There is, however, a need for more focused outreach and awareness raising for smaller corporates and other end users, such as retail users, so they can build a better understanding of what they are facing.”

Quantify exposure

Corporates with multi-currency funding and derivative arrangements referencing LIBOR – especially those facing liquidity headwinds – should seek to quantify their exposure and prioritise understanding of the impact LIBOR replacement will have on their near to medium-term cashflows, funding arrangements and related derivative portfolios, explains Raftopolous.

For those with contracts referencing LIBOR post-2021, the focus should be on understanding the impact that a move away from LIBOR will have on existing agreements, systems and policies as well as the accounting and liquidity implications. James Lewis, who leads KPMG’s Financial Services Risk & Regulatory Insight Centre, suggests 2019 will be a critical year for wider engagement with banks being relatively advanced in their thinking and planning, but other sectors lagging behind. “The historic problems around the robustness and resilience of LIBOR and wider IBOR benchmarks are well understood,” he adds.

“While there are significant benefits for the market in the new risk-free rate products, there is still a degree of reluctance to prioritise investing money on the transition.” As for whether corporates appreci - ate the benefits of transitioning to alternative overnight risk-free rates, Cankett points out that many larger firms have focused on the downsides of having to update systems and technology and some of the technical differences between forward looking term rates and backward looking overnight rates, as well as the impact on how they currently manage their cash and liquidity.

Risk-free rates are typically over - night rates with no term structure or bank credit risk component. They are currency specific, so the choice of rate between secured and unsecured differs across jurisdictions – for example, the sterling overnight index average or SONIA is unsecured, whereas the New York Federal Reserve’s secured overnight financing rate (SOFR) is, as the name suggests, secured. In addition, the publication times of these rates are different to that of LIBOR and each other.

Risk reward

Bakhshi observes that most corporates are aware of the scandals surrounding LIBOR, but adds that any change to contracts will cause value transfer concerns. “They may appreciate that this reform is helpful in the long term, but in the short term they don’t want to lose money because of this change,” he says.

According to Raftopoulos, many corporates prefer the term structure the existing LIBOR based framework provides and are concerned that a suit - able replacement term structure based on alternative risk-free rates will not be readily available, even if those risk-free rates are more reliable. “Inevitably, as the market develops there will be those corporates who will see opportunity in this change and invest in their capabilities to ensure that the associated risks are managed,” he adds.

The move to an overnight rate may mean corporates lose transparency to a benchmarked term structure and the move to a risk-free rate may give them a poorer understanding of how credit risk is evolving, acknowledges Mongelard. “However, it could also be a benefit as it may allow a natural break and corporates could renegotiate historic swaps,” he concludes.

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