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Accounting for change with the libor transition

With the London interbank offered rate being replaced with the sterling overnight index average (or, SONIA), John Mongelard looks at the impact of the Libor transition on hedge accounting

A field covered in golf holes each with its flag, one of whom has the word 'Profit', another 'Buy', another 'Sell', etc.The London interbank offered rate (Libor) is dubbed by some as the most important number in financial markets. It is used and perhaps overused for pricing, valuations, accounting, models, third-party contracts and risk systems.

The imminent change to Libor and its replacement with overnight rates – such as the sterling overnight index average (SONIA) – will be far-reaching. It will be more than a ‘find and replace’ task. This is because the replacements are very different in their construction to Libor. Unfortunately, the standard setters and markets are not replacing like for like, so the changes will have practical consequences both now and when we move to new rates after 2021.

Ahead of 2021 there are impacts as a consequence of the uncertainty of when and what Libor will be replaced with. Secondly, there are the impacts because of the long-term nature of current contracts, which will stretch across the transition period.

Term structure

Libor rates are currently available at different maturities – there are seven tenors for each Libor currency. There is a one month sterling Libor rate, a three month and a 12 month rate to name a few. This helps borrowers who want to reference a floating rate. For example, if a corporate has a floating rate loan with payments due every three months then they could agree to use the three month Libor rate of 0.77%. That way the corporate would know how much to pay in 90 days. However, in 2022 we may find ourselves with no three month Libor rate in sterling. Banks will no longer be compelled by the Financial Conduct Authority (FCA) to submit Libor rates after 2021. So will corporate borrowers be able to use the replacement risk-free rates in the same way?

Like for not like

Many of the replacement rates, like SONIA, are overnight rates, don’t have a term structure and are not forward-looking. This is because, to avoid the risk of manipulation, standard setters have said that important benchmarks should be based on actual transactions. For various reasons (such as reduced reliance on wholesale funding) the interbank market is almost solely based on overnight lending. If risk-free rates are likely to be overnight rates, how do you replicate the term rates you see with Libor?

Hedges not hedging

This will have a critical impact on hedge accounting in two important ways.

Hedge accounting primarily seeks to reduce profit and loss volatility and allow a modified treatment where a product, such as a loan, and an interest rate swap cancel each other out. Without it, reporters would have to separately record the volatility of both the loan and the corresponding derivative product in their income statements. But this treatment – hedge accounting – is not free. It is granted subject to certain tests being met.

Reporters will therefore face the immediate challenge of meeting those hedge accounting tests (forward-looking and retrospective) against the background of FCA CEO Andrew Bailey’s announced uncertainty around Libor’s future. If we know Libor will change in 2022 can we say that a Libor interest rate swap is hedging the interest rate risk on a Libor loan?

Nothing to see here

The accounting standard setters have proposed relief to the current hedge accounting rules that effectively say ‘pretend nothing is happening and carry on applying hedge accounting as you were’. Absent that relief, there could have been a risk of effectively ending hedge accounting. That would have been an enormous distraction and actually more confusing to the users of accounts. So the standard setters will provide relief and firms hopefully do not have to recognise volatile gains or losses in profit or loss.

Next phase

The recently announced relief is helpful for Phase 1 but the Phase 2 issues, dealing with the new rates and their specific issues, is a challenge that is increasingly pressing. The overnight risk-free rates are not the same as the current rates, which are forward-looking and have a bank credit spread.

And there is a wide range of differing timetables and approaches being adopted in markets internationally. This means we could see a range of issues could arise at different points in time due to the heterogeneous replacement strategies being considered in different markets.

Phase 1 - Issues leading up to IBOR reform

Phase 1 deals with pre-replacement issues – issues affecting financial reporting in the period before the replacement of an existing interest rate benchmark.

Phase 2 - Issues after IBOR reform is enacted

Once benchmark interest rates are replaced with the new risk-free rate deals we enter Phase 2. These are the replacement issues – issues that might affect financial reporting when an existing interest rate benchmark is replaced with a risk free rate and loan and other contracts are amended accordingly.

Hedge accounting tests

  • Highly probable test – for cash flow hedging, can you assert that you have a highly probable hedge attached to an underlying risk?
  • Accumulated other comprehensive income arising from cash flow hedges – are future transactions still expected to occur?
  • Do periodic prospective assessments of the effectiveness of designated hedges justify the application of hedge accounting?
  • Separately identifiable and reliably measurable – as Libor support falls away can it be defined as ‘reliably measurable’?
  • IAS 39 retrospective tests –how well will quantitative tests (80-125%) stand up