Why is the transition away from Inter Bank Offer Rates (IBOR) to new benchmark rates such a big deal?
Interest rate benchmarks currently underpin a huge range of financial products and valuations across multiple jurisdictions. The latest estimate is that $420 trillion of contracts are indexed to an interbank rate like LIBOR.
The term IBOR is used to refer to any interbank-offered interest rate such as sterling-LIBOR or USD-LIBOR. These IBORs are typically used in treasury, funding and leasing arrangements and are embedded in a range of risk and finance processes. With the proposed reforms, all IBORs are expected to cease to exist by 2022. However, exact implementation dates are still unknown.
The replacement of IBOR means that a survey-based benchmark rate will no longer be available. It will be replaced with an actual transaction rate that is demonstrable and verifiable – in other words, it will be a historical rate, not forward-looking. The term that’s being widely used for the new benchmark is ‘risk-free rate’ or ‘RFR’.
These changes could affect the interest rates that companies and banks use not only to calculate the interest due on a loan, but also the interest rate used to derive fair values for all types of financial instruments. Therefore, the change in IBORs have wide-ranging effects on companies - both from an operational point of view and an accounting perspective.
Working groups were set up for each of the five IBOR currencies: US dollar, UK pound sterling, Japanese yen, Swiss franc and Euro – and each working group is responsible for developing alternatives to IBOR within their home jurisdictions. All of these rates will behave differently to existing IBORs and to each other.
A replacement rate has now been determined in many jurisdictions and so begins the process of actually replacing the old IBOR benchmark rate with the new risk-free rate.
The International Accounting Standards Board (theIASB) has recently released its proposals for how to address some of the accounting issues associated with IBOR reform.
The IASB considers the related accounting points in two stages:
The proposals focus mainly on providing targeted relief for certain forward-looking requirements related to hedge accounting – both under IAS 39 Financial Instruments: Recognition and Measurement and IFRS 9 Financial Instruments. These proposed reliefs would apply until there is clarity on the timing and amount of cash flows from replacing existing IBOR with an alternative RFR. Under the proposals, a hedging relationship does not need to be discontinued, or amounts reclassified from a hedging reserve, just because of uncertainty over the timing and amount of future cash flows.
IBOR reforms don’t only affect hedge accounting, but a whole range of financial products and valuations across multiple jurisdictions.
For example, in a longer-term floating-rate loan, how will replacing the IBOR rate with an alternative RFR be accounted for? And can companies use this as an opportunity to amend other terms of the loan? These changes could trigger an assessment of whether the instrument has been modified, which could possibly lead to derecognising the instrument (and recognising a new instrument at fair value) or applying the modification requirements of IFRS 9.
Plan ahead. With the high levels of uncertainty surrounding the forthcoming IBOR reforms, early planning can help smooth transition to the new regime; it will help companies understand ways in which they might minimise potential risks. Companies can get a head start by preparing an inventory of potentially affected areas. One approach is to identify each area that uses IBORs (e.g. bank loans or lease agreements) and then determine the dependencies throughout the organisation - from finance and accounting, to business, legal, IT and operations.
Companies can also prepare by engaging with industry efforts and should actively seek to reduce new and existing reliance on LIBOR.
For more information, contact us and visit our Evolving LIBOR insights hub.
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