LIBOR is ending. Is your company ready?

Benchmark interest rates such as the London Interbank Offered Rate (LIBOR) are a core component of global financial markets, influencing borrowing and lending for all types of companies. LIBOR is calculated by submissions from various leading banks that estimate the rate that would be charged to borrow from other banks. It is used pervasively in various types of contracts, with the current contracts that reference LIBOR measuring in the trillions.

In July 2017, the UK Financial Conduct Authority announced that it would no longer compel Panel Banks to participate in the LIBOR submission process after the end of 2021. On the surface, this may appear to be a problem for just the financial sector, but many companies have been surprised at the breadth of their LIBOR exposure outside of financial instruments. The benchmark rate is used in contracts across functions, internal processes, and systems, including in lease contracts, accounts receivable contacts, procurement contracts, transfer pricing processes, intercompany funding contacts, and pension plan assets.

Given the lack of visibility into and potential breadth of exposure, as well as the diversity of impacted stakeholders and functions, it is imperative that business leaders take action.


Switching to preferred alternative rates

The Secured Overnight Financing Rate (SOFR) is expected to be the preferred alternative reference rate for US dollar financial products after 2021. Other jurisdictions are also eliminating IBOR rates and will adopt replacement rates as follows:

  • The Bank of England formed the Risk Free Rate Working Group, which recommended a reformed Sterling Overnight Index Average (SONIA) as the alternative unsecured risk-free rate for the Pound Sterling (GBP) LIBOR market.
  • The European Central Bank (ECB) formed the Working Group on Euro Risk-free Rates, which recommended the Euro Short-Term Rate (€STR) unsecured rate to replace EONIA
  • The Swiss National Bank selected the Swiss Average Rate Overnight (SARON), a secured reference rate based on data from the Swiss Franc repo market, as an alternative to CHF LIBOR.
  • The Bank of Japan formed a working group that ultimately recommended the Tokyo Overnight Average Rate (TONAR) as an unsecured overnight rate replacement.

Although Panel Banks will continue to participate in the LIBOR submission process until the end of 2021, market participants are actively preparing for the transition by identifying exposures, understanding the impact of those exposures, and taking action to modify both direct LIBOR references and contractual fallback provisions that will be triggered if LIBOR ceases to exist.
 

Seven challenges for businesses to get ahead of before LIBOR reform

1. Identifying LIBOR references in contracts

The issue:

Some corporations provide funding to their customers or clients as part of sale transactions or enter into other contracts such as leases and procurement contracts that contain references to LIBOR. These types of contracts and arrangements are frequently dispersed throughout the company making it difficult to readily identify a company’s exposure.

Why it matters:

  • Contracts outside of treasury such as procurement, supply chain and revenue contacts referencing LIBOR will need to be identified and assessed for impact to determine actions needed prior to the LIBOR transition.
  • The SEC staff highlighted that the change from LIBOR may necessitate renegotiation of existing contracts that lack fallback language with customers and updated fallback language in contracts for new customers.
  • Corporations that do not proactively manage their transition from LIBOR may expose themselves to conduct risk during an unorganized transition.
  • Customers/clients may be less educated about the change in reference rates and may need to be educated as part of the renegotiation/amendment process.
  • Some types of executory contracts (e.g. leases) are longer-term in nature and any new contracts entered into will extend beyond 2021 (or have the option to extend past 2021). The LIBOR transition should be considered when entering into these types of contracts so as to avoid additional costs that will be required to renegotiate contracts at a later date.
  • Significant resources may be required to review the number of contracts outstanding as part of a review of LIBOR exposure.

2. Operations may need to change

The issue

The transition away from LIBOR will require additional considerations for current systems and processes. Specifically, current systems may not have been designed to source replacement rates or may be unable to perform the calculations required to value financial instruments and accrue interest based on new reference rates. In addition, the impact that the LIBOR transition will have on processes such as transfer pricing and intercompany funding will need to be assessed.

Why it matters:

  • Valuation models, accounting and tax configuration, and data sourcing may need to be changed so that valuations, transfer pricing and accounting and tax records are accurate going forward.
  • Internal processes such as transfer pricing and intercompany funding may require that new analyses and updated procedures are in place so that appropriate rates and spreads are applied across the company.

3. Interest rate management

The issue:

Companies will need to evaluate their methods and approach to interest rate management and monitoring in order to accommodate the transition from LIBOR to alternative reference rates. As LIBOR is phased out, interest rate management programs should expect to encounter challenges from potential reduced liquidity for LIBOR-based products, basis risk between products and currencies, and general uncertainty around transition. Furthermore, lines of credit and borrowing facilities are often tied to LIBOR or another benchmark interest rate. These agreements may need to be renegotiated or amended to appropriately reflect the new benchmark interest rate and any subsequent credit spread adjustments required.

Why it matters:

  • Differences in transition or fallback provisions between debt, cash products and derivatives can create basis risk.
  • Challenges may arise with existing cross-currency basis risk management instruments that reference two floating rates.
  • Institutions need to understand to-be curve construction and behavior to appropriately develop risk management strategies and transition plans.
  • Companies should evaluate the economic impact of International Swaps and Derivatives Associations (ISDA’s) proposed changes relative to hedged exposure along with the economic impact of the fallback language for cash products.
  • Analyses of LIBOR exposure will allow corporates to develop appropriate transition and hedging strategies.

4. Liquidity management

The issue

As the end of 2021 nears, it is likely that LIBOR-based financial instruments will likely experience a decrease in liquidity. The trading volume changes of LIBOR-linked products could lead to changes in pricing, and companies will need to decide when to make the switch from LIBOR to SOFR or other risk-free rate (RRF) products.

Why it matters:

  • LIBOR-based financial instruments may be more difficult to liquidate because market demand may decline as the end of 2021 approaches.[12]
  • Volatility in SOFR (especially at period end) and uncertainties around the availability of forward-looking tenor rates may increase settlement risk.

5. Accounting and tax

The issue

As a result of the planned transition away from LIBOR, standard setting and regulatory bodies have begun to review their regulations and standards in contemplation of other reference rates and the practical implications of LIBOR reform. In particular, changes to accounting guidance, including hedge accounting and debt modification/extinguishment, will likely impact companies. Additionally, the IRS has been contemplating the impact of the transition away from LIBOR on issues such as deemed taxable exchanges based on modifications, credit spread adjustments, method of accounting changes for dealers in securities, and transfer pricing. These discussions are expected to continue as standard setters and regulators continue to respond to market developments. As a result, corporates should continuously monitor regulatory developments throughout the transition process.

Why it matters:

  • A change from LIBOR to SOFR could critically affect accounting conclusions. While the FASB is looking to provide relief in some areas, institutions will need to stay abreast of FASB decisions and consider the timing of their LIBOR transition efforts with the effective date of relief provisions provided by the FASB.
  • Limited historical replacement rate market data (e.g. volatility) could present challenges when valuing instruments such as options, caps and floors.

6. Debt management

The issue:

Existing financial products with scheduled maturities beyond 2021 that provide for LIBOR-based interest payments will need to be modified to reference SOFR or another alternative rate. Additionally, new financial instrument contracts that reference LIBOR and extend beyond 2021 will need to contain fallback provisions that specify an alternative rate other than LIBOR that will be used if and when certain trigger events occur. Financial instrument contracts that do not contain relevant fallback provisions could result in a negative economic impact or an invalid reference rate. Even cash products that contain fallback language that references the end of LIBOR are still highly susceptible to value transfer, as no perfect mechanism exists to adjust for the spread between LIBOR and SOFR or other alternative reference rates.

Why it matters:

  • A more than minor modification to a contract may be deemed an extinguishment of a debt instrument, resulting in the recognition of gains or losses.
  • Transfer pricing or tax issues could arise if intercompany funding or other agreements are not appropriately modified to include fallback language.

7. Investment management

The issue:

As new alternative reference rate products become available, investment committees will need to prepare for future issuances by understanding the liquidity and pricing in the market for LIBOR products compared to products with alternative rates. This understanding will permit investment committees to determine how the alternative rates complement or require adjustments to existing strategies. We expect first mover advantages for those institutions who can strategically transition their portfolios from LIBOR to SOFR and other risk-free rate-linked products in a timely manner. Proactive institutions are actively monitoring their investment strategy to minimize the acquisition of LIBOR-based products with maturity dates extending beyond 2021. Any strategy for minimizing LIBOR exposure should consider direct exposure (holdings of LIBOR-linked products with maturity dates extending beyond 2021) and indirect exposure (products, valuation techniques, systems, etc. that may have an underlying/input that is impacted by changes in LIBOR).

Similar to the changes for investment portfolios, corporates that manage long-dated pension assets will need to monitor those investments and determine if the terms of the investments, which may have been determined far before LIBOR reform was contemplated, require adjustment.

Why it matters:

  • Changing investment strategies and/or exiting existing positions in an orderly manner to reduce LIBOR exposure can require an extensive amount of time. Analyzing and addressing LIBOR exposure now can reduce the likelihood of unfavorable impacts.
  • Valuation models for investments may need to be modified to incorporate SOFR or other alternative rates.

Steps for LIBOR reform at your company

Business leaders should establish a LIBOR transition team with functional leaders, an executive sponsor and an operational program leader. Create a major milestone plan and draft budgets consistent with industry timelines, such as the ARRC - Paced Transition Milestone Plan.

Create a LIBOR education package that is up-to-date on market developments for all functions. The transition team should identify other key stakeholders, including company subsidiaries, procurement, vendors, and investment managers, and develop interaction strategies. Stay informed about lenders’ transition progress and any amendments to agreements they may plan to make.

Work with the functional leaders to establish objectives and scope of an initial impact assessment, which should identify exposure to LIBOR across the company as well as its financial and operational impacts.

Define scope, approach, and criteria for the risk assessment. Once the scope has been developed, the team can map the technical environment, evaluate any information security requirements, and agree on data transfer models for the data test population. Execute data extraction and analysis to identify LIBOR references and aggregate results to determine any required remediation plans.

The company should assess financial and operational impacts. If needed, identify alternative reference rates or language that can replace current LIBOR-based provisions. The company should develop a plan to interact with and renegotiate contracts with customers/service providers with outstanding contracts to ensure a smooth transition.

Once these steps are completed, the company should begin issuing and/or transacting in SOFR-linked products and identify the impact of these products on the existing infrastructure and any financial implications.

Benefits of proactive action

There are opportunities for institutions to use LIBOR reform to improve processes, strategies, and customer/service provider relationships. For example:

  • Compliance with SEC expectations that corporate institutions understand and disclose applicable information regarding their LIBOR exposure and transition. The SEC staff provided a list of considerations for companies with LIBOR exposure extending past 2021.
  • Do you have or are you or your customers exposed to any contracts extending past 2021 that reference LIBOR? For companies considering disclosure obligations and risk management policies, are these contracts, individually or in the aggregate, material?
  • For each contract identified, what effect will the discontinuation of LIBOR have on the operation of the contract?
  • For contracts with no fallback language in the event LIBOR is unavailable, or with fallback language that does not contemplate the expected permanent discontinuation of LIBOR, do you need to take actions to mitigate risk, such as proactive renegotiations with counterparties to address the contractual uncertainty?
  • What alternative reference rate (for example, SOFR) might replace LIBOR in existing contracts? Are there fundamental differences between LIBOR and the alternative reference rate – such as the extent of or absence of counterparty credit risk – that could impact the profitability or costs associated with the identified contracts? Does the alternative reference rate need to be adjusted (by the addition of a spread, for example) to maintain the anticipated economic terms of existing contracts?
  • For derivative contracts referencing LIBOR that are utilized to hedge floating-rate investments or obligations, what effect will the discontinuation of LIBOR have on the effectiveness of the company’s hedging strategy?
  • Does use of an alternative reference rate introduce new risks that need to be addressed? For example, if you have relied on LIBOR in pricing assets as a natural hedge against increases in costs of capital or funding, will the new rate behave similarly? If not, what actions should be taken to mitigate this new risk?
  • Digitizing contracts can help companies understand their LIBOR exposure, reduce costs and streamline client onboarding, contracting, and negotiating. Corporate departments can use contract digitization to find patterns across the full spectrum of transactions, improving risk analysis and review speed by accounting and compliance. It may be easier to alter terms such as fallback language if a company can access digitized records during contract negotiations.
  • By promoting collaboration, agility, innovation, and efficiency across the business, corporates can empower teams, streamline decision making, and reduce costs.

A wait-and-see approach to LIBOR transition could lead to adverse outcomes for firms that do not proactively manage the transition. Meanwhile, firms that are early movers in the LIBOR transition could use the upheaval to demonstrate their customer focus. If you are concerned with your company’s exposure to LIBOR, reach out to PwC’s LIBOR contacts below to discuss best practices for reference rate reform.

Contact us

Jonathan Bergeson

Partner, PwC US

Mary Perrotta

Partner, PwC US

Nick Milone

Partner, PwC US

Marguerite Duprieu

Director, PwC US

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