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