A World Without LIBOR: A New Financial Order?

Courtesy of Xing Huan, Gary J. Previts, and Antonio Parbonetti

Introduction

On June 27, 2012, news of Barclays being fined for manipulating the daily setting of the London Interbank Offered Rate (LIBOR) and Euro Interbank Offered Rate (EURIBOR) flooded the media. Nearly eight years later, the transition away from LIBOR is still a work in progress. Since the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB) addressed the LIBOR phaseout, the topic has drawn considerable attention. In our recent paper, we revisit a number of landmark legislations that contributed to the LIBOR provisions, discuss some critical aspects related to financial system design, and propose a conceptual model of banking regulation. In this blog post, we focus on the responses of accounting and financial regulators to the LIBOR transition.

LIBOR Overview

LIBOR was first published in 1986 under the auspices of the British Bankers’ Association (BBA). It represented the cost of short-term wholesale funds for major banks in the London interbank lending market. Thomson Reuters, to whom major banks submitted their cost of borrowing unsecured funds in ten currencies for fifteen maturities, calculated and published LIBOR each business day. This amounted to 150 LIBOR rates reported daily. The submission process required contributing banks to evaluate the rates at which money might be available in the interbank market. The process for rate submission, although based on the submitters’ knowledge of the market, was mostly hypothetical and subjective.

With the boom of the Eurodollar market in the 1950s and 1960s, and the innovation of interest rate swaps in the 1970s, LIBOR became a reference rate for valuing financial instruments and establishing the terms of agreements for short-term floating rate contracts, such as interest rate swaps. Given the rise of derivatives and the decline in interbank lending, especially after the 2008 financial crisis, LIBOR was principally used to value derivatives by the time the scandal erupted in 2012.

Since the LIBOR scandal broke out, global financial regulators made a series of attempts to phase out LIBOR. On January 31, 2014, the Intercontinental Exchange Benchmark Administration (ICE) took responsibility for administering LIBOR from BBA. Regulators in a few jurisdictions around the world have initiated reference rate reform to identify alternative reference rates that are more observable, or transaction-based, and therefore less susceptible to manipulation. Several alternatives, such as Broad Treasury Financing Rate (BTFR) and Secured Overnight Financing Rate (SOFR), have been proposed to replace LIBOR. However, replacing LIBOR is not just a matter of replacing one rate with another. As a benchmark rate, LIBOR plays a role in valuing most financial assets – valuations that are reflected in financial reporting. The transition to a new reference rate will hence result in many contracts being modified.

Regulatory Response

Accounting regulators are very concerned with the cost of the LIBOR shift. Both FASB and GASB have eased the financial reporting requirements to facilitate the market transition from existing reference rates to alternatives. FASB will allow contracts to continue after the shift of reference rates, provided certain criteria are satisfied.[1] The International Accounting Standards Board (IASB) has also recently amended its standards for financial instruments (i.e., IAS 39, IFRS 9, and IFRS 7) to prepare for the change. These amendments involve (1) modifying specific hedge accounting requirements to provide relief from the potential effects of the uncertainty arising from the LIBOR phaseout and (2) requiring firms to provide additional information to investors about their hedging relationships that are directly affected by these uncertainties. Like most considerations in accounting regulation, these decisions concerning exceptions are made after assessing the expected benefits and perceived costs, to reduce the cost of accounting and financial reporting ramifications of replacing LIBOR with other reference rates. In detail, these amendments cover relief to four areas in the accounting standards: (i) highly probable requirement, (ii) prospective assessments, (iii) hedge effectiveness assessment, and (iv) separately identifiable risk components.

Highly Probable Requirement

According to both IAS 39 and IFRS 9, the precondition for a forecast transaction being designated as a hedged item is that transaction must be highly probable to occur. Forecast LIBOR-based cash flows may not meet the highly probable requirement as a result of uncertainties arising from the LIBOR transition.[2] The amendment’s solution to this issue is to allow companies to assume that the interest rate benchmark on which the hedged cash flows are based will not be altered as a result of the reform, thereby satisfying the highly probable requirement.

Prospective Assessments

A hedging relationship can qualify for hedge accounting only when there is an economic relationship between the hedged item and the hedging instrument (IFRS 9), or the hedge is expected to be highly effective in achieving exposure offsetting (IAS 39). This is referred to as prospective assessments, which companies must demonstrate regularly. Prospective assessments may be affected due to the LIBOR transition, which could result in discontinuation of hedge accounting when the future cash flows of hedged items and hedging instruments are altered in a manner that does not pass the prospective assessments. The exception made to this aspect is to make it possible for companies to assume that the interest rate benchmark on which the hedged item, hedged risk, and/or hedging instrument are based, is not altered as a result of the reform.

 Hedge Effectiveness Test

 Under IAS 39, hedge accounting can be applied only if a hedge is effective (i.e., the ratio of the change in derivative value to that of the hedged item falls within a range of 80–125% over the life of the hedge). This requirement is commonly known as the 80/125 rule. Uncertainties arising from the reform could alter the hedge effectiveness test results, which in turn leads to discontinuation of hedge accounting if the 80/125 rule is violated. To address this issue, IASB amended IAS 39 to exempt companies from undertaking the hedge effectiveness test if hedging relationships are directly affected by the reform. However, this exception does not change the requirement to measure and recognize all ineffectiveness in profit or loss.

 Separately Identifiable Risk Components

Both IAS 39 and IFRS 9 require a risk component to be separately identifiable to qualify for hedge accounting. Reforming the interest rate benchmark would affect the market structure, which in turn influences the assessment of whether non-contractually specified risk components are separately identifiable. IASB amended IFRS 9 and IAS 39 to require companies to apply the separately identifiable requirement only when an instrument is initially designated as a hedged item in a ‘macro hedge’ relationship. The hedged item will not be reassessed at any subsequent re-designation in the same hedging relationship.

In contrast, financial regulators’ response to the LIBOR phaseout mainly surrounds risk identification and mitigation. This is in line with the well-established view that the general purpose of financial reporting is to provide information to firms’ outsiders to support a wide range of decision contexts and contractual agreements. Meanwhile, financial regulation mainly seeks to protect the financial system as a whole by limiting the frequency and cost of systemic crises. The Securities and Exchange Commission (SEC) has stressed that the risks associated with the discontinuation and transition of LIBOR will be exacerbated if the work necessary to facilitate an orderly transition to an alternative reference rate is not completed promptly. To effect the transition from LIBOR, the SEC has encouraged market participants to (1) identify existing contracts that extend past 2021 to determine their exposure to LIBOR and mitigate the risks related to the transition from LIBOR; (2) consider whether contracts entered into in the future should reference an alternative rate such as SOFR or, if such contracts reference LIBOR, include effective fallback language; and (3) identify, evaluate, and mitigate other consequences the LIBOR transition may have on their businesses (e.g., strategy, products, processes, and information systems).

Conclusion

The LIBOR scandal exposed many problems. Starting in the 1980s, the LIBOR system was ground-breaking, but no one realized that it could be so thoroughly exploited or that it would take so long to discover such misconduct. LIBOR is expected to phaseout in 2021, and the justification for using substitutes such as SOFR is that they are transaction-based. Transaction-based benchmark rates better reflect how financial institutions fund themselves and are less vulnerable to manipulation. Thus, the idea of using a transaction-based/derived benchmark rate aligns with the logic of fair value accounting.

 

[1] Companies only have to account for a contract as a new one if the shift to a new reference rate results in a change in future cash flows of that contract exceeds 10%.

[2] This happens when the future cash flows are based on an alternative nearly risk-free rate instead of LIBOR.

Leave a Reply

Leave a Reply

Your email address will not be published. Required fields are marked *