7 minute read 15 Jan 2018
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How transition from IBOR to RFR will impact businesses

Authors

EY FS Insights

Minds Made for Financial Services

Shankar Mukherjee

EY United Kingdom Financial Services Advisory Partner

Banking & Capital Markets transformation leader. Passionate believer in the ability of better risk management to drive business growth.

7 minute read 15 Jan 2018

Companies across industries are experiencing issues and challenges due to transition from Interbank Offered Rates (IBORs) to Risk-free Rates (RFRs).

The transition from Interbank Offered Rates (IBORs) to so-called Risk-free Rates (RFRs) raises many issues and challenges for companies across industries and jurisdictions. One key area to consider is the impact on financial accounting and reporting and, most importantly, on hedge accounting. At their meeting on 20 June 2018, the International Accounting Standards Board (IASB) “noted the urgent need for IBOR reform and added a research project on the topic to their agenda.” The findings from this project will be discussed at future IASB meetings, with the potential to change accounting standards.

Regulators across the globe are encouraging the move from IBOR to RFRs in response to dwindling transactions in the interbank wholesale funding markets; the extensive use of IBORs in derivatives markets where an RFR is more appropriate; the use of expert judgment in IBOR submissions; and the potential risk of misconduct. 

Currently, the financial markets are attempting to navigate the uncertain environment raised by the anticipated transition from IBOR interest rate benchmarks (such as London Interbank Offered Rates or LIBORs and Euro Offered Rates or EURIBORs) to alternative RFRs. Trillions of dollars of financial instruments reference IBOR benchmarks. 

Transition from IBORs to alternative RFRs will affect a broad range of product types across multiple market segments. What this transition would mean in practice is that both new and legacy transactions (including over-the-counter (OTC) derivatives, exchange-traded derivatives (ETDs), securitized products, loans, bonds and mortgages) that currently reference an IBOR benchmark will, in most cases, need to reference a new RFR. This also applies to transactions not directly referencing an IBOR benchmark but valued using one as an input (for example, discounting cash flows now would need to be valued using an alternative RFR benchmark).

Despite the uncertainties around the end state and the timing of the transition, any company with loans, derivatives, bonds or products referencing an IBOR as a rate, is likely to be affected.

What this mean for companies

Most companies (not just banks) will be affected to some extent by the transition from IBOR. Despite the uncertainties around the end state and the timing of the transition, any company with loans, derivatives, bonds or products referencing an IBOR as a rate, is likely to be affected. The operational changes required also will impact many areas within the organization. 

For financial services firms, activities such as sales and trading, treasury, risk management, legal and operations will be affected, and most companies will see some impact on their accounting and financial reporting functions. There are specific accounting challenges not only for hedge accounting but also valuations. The systems, processes and controls surrounding these activities will also be affected.

Hedge accounting challenges 

Two key issues for hedge accounting need to be addressed before transition from IBOR: 

  1. Cash flow hedges: Are the designated cash flows beyond 2021 still highly probable? If not, hedge accounting may need to end. And, if the cash flows are no longer probable, the amounts currently deferred in the cash flow hedge reserve may need to be released to profit or loss immediately.

    Cash flow hedge accounting is likely to continue as long as the variable cash flows that are the subject of the hedge remain highly probable. The effectiveness of a hedge of IBOR risk can be measured reliably, and hedges are considered to be highly effective.

    The bigger concern is that at some stage in the future IBOR (before it is replaced) will no longer be the main basis for the interest rate market. Thus, it would no longer be possible to assert that future floating rate cash flows are equivalent to those based on IBOR, and the liquid market for IBOR derivatives would cease.
  2. Amendment to documentation. Does an amendment of the hedge documentation to anticipate a change in the designated benchmark rate give rise to designation or re-designation of the hedge relationship? 

    Entities may seek to amend their hedge documentation to anticipate a possible replacement of IBOR by a new benchmark. The key question here is whether this amendment to the documented hedged risk would give rise to a de-designation of the original hedge relationship and designation of a new one. The implication of a de-designation and re-designation is that the new hedge relationship would include a derivative that has a non-zero fair value, which introduces a potentially significant new source of hedge ineffectiveness for cash flow hedges

Other accounting challenges

  1. Valuation. If IBOR quotations are maintained after 2021 and are used to price legacy instruments, there is a risk that these would be classified as level 3 for the purposes of IFRS 13 Fair Value Measurement, and disclosed as such, if they are not quoted in an active market. IBOR may also become less liquid and therefore less reliable for valuation purposes. 

    Even before 2021, it may prove challenging to value derivatives if IBOR forward curves can no longer be generated for the life of the instrument. This also has a secondary impact on regulatory capital by way of impacting Prudential Valuation Adjustment (PVA), Article 105 of Regulation (EU) No 575/2013. 

    Wherever entities have used IBOR curves as a proxy for RFRs to value financial instruments, adoption of an overnight rate will require a change of process and a different valuation. A change in value would be viewed most likely as a change in estimate, reflected in profit or loss.
  2. Modification. On transition to a new rate, when the terms of existing cash instruments and derivatives are modified, a key accounting question will be whether the change in terms is sufficiently substantial to result in derecognition of the old instrument and recognition of a new one.
  3. Classification (IFRS 9 only)
    • SPPI* criterion. There is a significant possibility that interest on overnight products will be calculated using a compounded daily rate, to be paid on a quarterly (periodic) basis. To make this operable, it is possible that the period over which the interest is calculated could start as much as five days before the beginning of the quarter or period and end five days before the end.

      There is a risk that, for an asset that pays a daily compounded overnight rate, this non-alignment could lead to the assessment that the interest does not compensate the lender for the time value of money and credit risk. If so, such a cash instrument may not be eligible to be recorded at amortized cost. This risk is relatively small, since IFRS 9 permits what it describes as a modified time value of money to still be eligible for amortized cost, if the effect is not significant in many cases.
    • Business model criterion (IFRS 9 only). There is also a risk that in the run up to transition to the new rate, if an entity acquires floating rate financial assets that it expects to derecognize on transition to the new rate, it will not be possible to assert that the asset is held for collection of cash flows. If that is the case it may need to be recorded at fair value through profit or loss (although gains and losses may be modest on floating rate assets).

What should companies do 

There are several issues for IFRS preparers to consider:

  • As part of their IBOR transition program, they should identify long-dated hedge accounting transactions that might be affected by a change in the designated benchmark. 
  • An impact assessment should be undertaken to determine the technical accounting considerations and potential impact on hedge accounting relationships. 
  • For any new financial instruments issued in the transition period (or until further clarity is achieved), entities should consider amending the wording in their hedge documentation to include reference to a “replacement benchmark rate” to avoid the interruption of cash flow hedge accounting for this portion of the population. 
  • Companies should also think about the broader organization-wide implications for the determination of fair value, modifications and classification of financial instruments, including secondary impacts on regulatory capital such as through prudential valuation.
  • Companies should also consider the implications for processes and controls which should not be underestimated. 

Summary

Not just banks, most companies will be impacted to certain extent by the transition from IBOR. In financial services firms, sales and trading, treasury, risk management, legal and operations will be affected along with some impact on accounting and financial reporting functions. 

About this article

Authors

EY FS Insights

Minds Made for Financial Services

Shankar Mukherjee

EY United Kingdom Financial Services Advisory Partner

Banking & Capital Markets transformation leader. Passionate believer in the ability of better risk management to drive business growth.