With the introduction of reference rate reform and the expected phaseout of the London Interbank Offered Rate (LIBOR) in 2021, now is the time for financial services companies to consider potential implications and plan for the transition.
Reference rate reform refers to the transition toward new reference rates and away from the LIBOR and other interbank-offered rates. LIBOR is currently the most commonly used reference rate in the global financial market, so a large volume of contracts and other agreements will be impacted by this phaseout.
Stakeholders can plan for the transition by better understanding exposure to LIBOR and taking the following steps well in advance of the phaseout:
- Assess the transition’s operational and accounting effects on financial reporting
- Review existing contracts to identify agreements indexed by LIBOR
- Plan for future contracts with an alternative reference rate
Following is an overview of transition strategies, potential challenges, and seven key questions financial services companies should consider when navigating the transition away from LIBOR.
What’s my level of exposure to LIBOR?
To determine your company’s exposure to LIBOR, identify and assess existing LIBOR contracts in your current portfolios. This will require an assessment of all contracts that reference LIBOR, including loans, derivatives, debt, leases, and any other contract or agreement.
Contracts indexed with LIBOR will likely be structured in one of two ways:
- LIBOR is listed as the reference rate as a stand-alone, with no fallback language.
- LIBOR is listed as the reference rate, but the agreement provides a replacement index if LIBOR ceases to exist.
As part of the inventorying of agreements, companies should understand existing fallback provisions and exposure in both scenarios.
What’s the logical replacement of LIBOR?
It’s important to monitor and understand the effects of alternative reference rates. The Alternative Reference Rates Committee (AARC), a group of private-market participants convened by the Federal Reserve Board and the Federal Reserve Bank of New York to help ensure a successful transition from LIBOR, has recommended the Secured Overnight Financing Rate (SOFR) as its recommended alternative.
SOFR is a widely monitored reference rate alternative that represents the average rate at which institutions can borrow US dollars overnight while posting US Treasury bonds as collateral. Given that LIBOR is an unsecured rate and SOFR is a secured rate, there will likely be a spread differential between the two indices. It’s possible that a one-time spread adjustment may be required.
SOFR is still new and has recently experienced volatility that continues to be addressed by the AARC. It will require time for development of a term-rate structure for SOFR to become viable for cash products, such as commercial mortgages.
How will my operational systems handle the change?
To navigate the changes, your company should review system operational requirements for managing a change in index and coordinate with stakeholders, including loan servicers, system administrators, and end-users. It may be beneficial to encourage your stakeholders to voluntarily adopt SOFR or another agreed-upon benchmark rate. For a period of time, there may be legacy LIBOR contracts and new contracts referenced off of another benchmark rate.
Should we be doing something now for newly entered agreements?
If your company is entering into loans, derivatives, debt, or any other kinds of contracts, consider if you have adequate disclosures or fallback provisions for a change in benchmark rate. Be cautious about overreliance on existing provisions and consider modifying them for new floating-rate contracts.
Have any measures been passed to help companies navigate the change?
In September 2019, the Financial Accounting Standards Board (FASB) issued a proposed Accounting Standards Update (ASU) that provides temporary guidance to help mitigate the effects of this change as it pertains to financial reporting for both contract modifications and hedging programs. The ASU offers optional expedients for contract modification and hedging relationships. Read more about proposed standards in our article.
How will derivative hedging instruments be affected by a change in reference rates?
Hedging instruments and hedged items that are tied to LIBOR may be ineffective following the change in reference rates, so it’s important to identify the effects of new and legacy benchmark rates on current and future hedging programs. The change also calls into question hedging designations for instruments tied to LIBOR with maturities after 2021.
As noted above, the FASB has proposed relief to address this concern, but companies need to understand that the accounting relief is temporary, expiring on January 1, 2023, so action should be taken.
Are there any tax implications?
It’s important to plan for possible tax consequences, including considering if a change in interest calculations for debt instruments would constitute a significant modification of the debt. If it does, this could result in tax consequences for the debt issuer and holder as well as possible recharacterization of the debt for tax purposes.
We’re Here to Help
If you’d like to learn more about how this change affects your company, contact your Moss Adams professional. You can also see our Alert, which summarizes the proposed accounting relief arising from reference rate reform.