4 minute read 1 Mar 2021
LIBOR transition

What you need to know about LIBOR transition and how to set up your firm for success

Shiva Iyer
By Shiva Iyer

EY India Financial Accounting Advisory Services (FAAS) Partner

Helping clients embrace digital disruptions and drive change in the finance, regulatory and treasury functions. Financial services advisor and strategist. An avid sports enthusiast and career coach.

4 minute read 1 Mar 2021
Related topics Financial accounting advisory services
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About USD 350 trillion worth of contracts across the globe are pegged to London Interbank Offered Rate (LIBOR), which is the key interest rate benchmark for several major currencies. This rate will cease after December 2021 and will be replaced by Alternative reference rates (ARR) also known as Risk free rates (RFR).

Benchmark interest rates are a core component of financial markets, influencing borrowing and lending for all types of market participants funds, etc across a myriad of financial instruments. Retail and commercial loans, corporate debt, securitized products, and the derivatives markets all rely on these benchmark reference rates for the pricing and hedging of interest rates and other risks.

The London Interbank Offered Rate, or LIBOR, is one of the most common series of benchmark rates referenced by contracts measured in the trillions of dollars across global currencies. About USD 350 trillion worth of contracts across the globe are pegged to LIBOR which is the key interest rate benchmark for several major currencies. The maturities on financial products based on LIBOR ranges from overnight to a year and is and the entire rate setting mechanism is administered by Intercontinental Exchange (ICE). Following the global financial crisis of 2008, calls grew to reform the process used to price LIBOR due to the way the rate was developed based on professional judgment by contributing banks, the lack of transactional data from which to derive such rates, and the potential for the rate-setting process to be manipulated as seen by regulatory enforcement and litigation in recent years.

As a result collectively the global regulators from the developed capital markets decided that the publication of the LIBOR will cease after December 2021 and will be replaced by Alternative reference rates (ARR) also known as Risk free rates (RFR) However as recently as 30 November 2020, ICE had announced its intention to extend the use of USD LIBOR till June 2023 for almost all maturity tenors except for one week and two-month tenors that will cease by December 2021. While ICE has issued a consultation to this effect, it seems to have in principle support from the UK and US regulators for the extension. The shift away from the most widely used interest rate benchmarks is an immense change to global finance that will have far-reaching impacts.

India’s LIBOR linked exposure to major financial contracts is approximately INR 39.9 Lakh Crore# (US$ 532 Billion)

Annual currency borrowing for top 10 NBFCs

The NBFCs having exposures linked to the LIBOR rate need to be mindful of impact on treasury, tax, accounting processes along basis risks and value transfer.

Notional exposure of top 10 NBFCs

The NBFCs having exposures linked to the LIBOR rate need to be mindful of impact on treasury, tax, accounting processes along basis risks and value transfer. We highlight some of the key challenges that will need to be addressed by NBFCs (“Company” or “companies”) as also to banks and other institutions as the publication of the LIBOR will cease after 2021. 

  • Contract amendments

    Amending contracts is a time-intensive process that requires coordination across departments (e.g., treasury, procurement, legal) and agreement with lenders, borrowers and other counterparties. LIBOR exists as a reference rate in a variety of contracts and preparing a comprehensive inventory can be challenging. Planning now for how and when to negotiate with borrowers and other counterparties can facilitate an orderly and timely transition.

  • Financial accounting, reporting and tax risk

    Contract amendments typically require a company to determine whether the change results in a taxable event or has a financial reporting impact, such as hedge de-designation or debt extinguishment. Global regulators and standard setters have proposed targeted relief from certain financial reporting and tax impacts for transactions that fall within stated parameters. Companies need to assess how the guidance will apply to their facts and circumstances and should not assume blanket relief. In addition, companies or counterparties may use this as an opportunity to make other contract changes. These additional amendments may impact whether the transaction qualifies for relief.

  • Impact on treasury

    Treasurers at large companies and financial services firms need to take stock of the most obvious potential hazards in the LIBOR transition. For instance, managing corporate debt and managing liquidity will become difficult if LIBOR-based assets become harder to sell as 2022 approaches. Banks and NBFCs will be expected to help their corporate clients address these issues.

  • Business changes on account of differences between ARRs and LIBOR

    Companies may need to change how interest and cash flow is managed because interest payments on some debt issuances (e.g. under Secured Overnight Financing Rate - SOFR) are not set until the end of the period while most LIBOR interest payments are known at the beginning of the period.

  • Basis risk and value transfer

    Companies are likely to experience some degree of value transfer as a result of amendments to replace LIBOR. For example, the parties to a LIBOR-indexed contract may agree to apply SOFR plus or minus a fixed spread. Although amendments may have been made with the objective of the transition being value-neutral, by the time of transition, the contract’s value will likely change because:

    • there may be timing differences between when negotiations are complete and the change to ARRs like SONIA/SOFR occurs,
    • practical expedients may be necessary given the potential complexity with calculation; for example, the specified spread may be based on a historical average rather than the actual spread between LIBOR and the ARR, and
    • the term structures of LIBOR and the ARRs are different.

  • Reputational risk

    Companies need to develop LIBOR transition plans and proactively communicate with regulators, investors, lenders, customers, and other counterparties.

    • Regulators have made it clear they expect thoughtful transition plans and disclosures to address the risks of LIBOR transition.
    • Communication of a clear understanding of exposure and a plan for transition is important for investor confidence.
    • Financial services and other companies will need to develop a plan to manage their business conduct with customers impacted by the change. The plan should include oversight and controls of those business units that interact and negotiate with customers.

  • Impacts to operations, IT, Data and models

    The introduction of ARRs may necessitate large-scale and potentially costly changes to models, data, and technology. Companies will need to:

    • inventory models across all departments that rely on LIBOR for updates and obtain appropriate approvals of any model changes,
    • assess new ARR data needs and determine how and where to source those data elements, considering evolving capabilities of third-party vendors, and
    • enhance current systems, whether internal or external, that may not be equipped to support contracts referencing ARRs.

  • Proactive communication to stakeholders

    Proactive communication to internal and external stakeholders will provide transparency. Early communication with lenders and investors will give companies a sense of their concerns and how best to interact with them to modify contracts.

    A careful explanation of what you’re trying to undertake will go a long way in reassuring your counterparties that your goal in amending terms is to get things right, not to take advantage.

    Investors and regulators will also be expecting you to thoughtfully navigate the LIBOR transition. Be transparent with them about your transition plan and communicate with investors about how LIBOR impacts them and what your company is doing about it.

LIBOR exists as a reference rate in a variety of contracts and preparing a comprehensive inventory can be challenging. Planning ahead for how and when to negotiate with borrowers and other counterparties can facilitate an orderly and timely transition for NBFCs.
Shiva Iyer
Associate Partner, Financial Accounting Advisory Services (FAAS), EY India

(EY India’s Mangirish Gaitonde and Kiran More have also contributed to this article).

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Summary

The move away from LIBOR is one of the biggest changes in the global financial markets and NBFCs who proactively assess the impact can take appropriate actions to make the most of the shift in the underlying rates.

About this article

Shiva Iyer
By Shiva Iyer

EY India Financial Accounting Advisory Services (FAAS) Partner

Helping clients embrace digital disruptions and drive change in the finance, regulatory and treasury functions. Financial services advisor and strategist. An avid sports enthusiast and career coach.

Related topics Financial accounting advisory services
Upvote