Treasurers need to limber up for Libor reform

The Financial Conduct Authority (FCA) is just one regulator that has directed firms to move away from the use of benchmarks such as the London interbank offered rate (Libor) in favour of alternative overnight risk-free rates.

The problem for corporate treasurers is that while Libor will receive what the FCA describes as limited support after 2021, trillions of dollars of IBOR or interbank offered rate-related transactions will not have matured by then.

Sangdeep Bakhshi, who works for EY advising corporate clients on interbank offered rate reform, says companies need to know what their inventory is in order to determine how benchmark reform will impact their organization. “For example, we know that derivatives are impacted, but Libor is also referenced in some commercial contracts,” he says.

One of the significant challenges related to reporting is how firms are going to handle the hedging treatment and its impact on financials and reporting, explains the head of KPMG’s Financial Services Risk & Regulatory Insight Centre, James Lewis.

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Longer term

One of the main longer-term considerations is 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 cash flow hedges, documentation of the hedged risk and hedge effectiveness testing,” says PwC director Mark Randall.

Fair value measurement and leasing payments are also affected. Fair value could be impacted 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 (that is, when the IBOR-based rate is updated, similar to a floating-rate loan).

“In addition, several balance sheet line items might be indirectly impacted by IBOR replacement if they use an IBOR-based discount rate,” says Randall.

“Particular areas that might be affected include IAS 37 provisions; insurance assets and liabilities under IFRS 4 and IFRS 17; contract assets arising from revenue contracts with customers under IFRS 15; and pension liabilities under IAS 19, as well as value-in-use models for assessing non-financial asset impairment under IAS 36.”

Corporates with multi-currency funding and derivative arrangements referencing Libor – especially those facing liquidity headwinds – should seek to quantify their exposure and prioritize understanding the impact Libor replacement will have on their near to medium-term cash flows, funding arrangements and related derivative portfolios.

Concerns

That is the view of fellow PwC director Christopher Raftopoulos, who adds that 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.

Any change to contracts will cause value transfer concerns. However, Raftopoulos reckons that 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.

Corporates that are fully aware of the implications of transition are more likely to be proactive – for example, where a facility needs to be renewed many are considering switching it from Libor to Sonia (Sterling Overnight Index Average) now to reduce their Libor exposures.

Inevitably, some firms are concerned about 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. A key consideration for corporates is whether their treasury management systems will be able to cope with the alternative overnight risk-free rates.

Sander van Tol, a partner at treasury consultancy Zanders, says corporate treasurers face a complication in the shape of amendments to the new yield curves and related underlying contracts.

Based on his conversations with system providers, he says that while the changes that need to be made are to some extent already possible in current systems, they are likely to be time-consuming and costly to do all at once – he likens the process to having to replace all existing legal contracts or the old benchmark rates of the financial products recorded in a treasury management system.

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