Financial services groups use benchmark interest rates to assist with business functions ranging from lending to mitigating interest rate risks. One of those benchmark interest rates, the London Inter-Bank Offered Rate (LIBOR), is effectively going away after 2021.
On the surface, the loss of a benchmark interest rate appears to only affect lending and financial services organizations. The repercussions from the loss of LIBOR, however, could be felt much more broadly. Many contracts, loans, and other types of financial business arrangements may have references to LIBOR that will need to be modified.
A Brief History of LIBOR
Traditionally, businesses across the world have turned to LIBOR as a benchmark tool for interest rates and derivatives contracts. Contributing financial institutions have been required to submit certain types of financial information to the LIBOR, which has created a vast warehouse of information. The LIBOR includes rates for five different currencies—the American dollar, the British pound, the Japanese yen, the Euro and the Swiss franc. It also includes information for various maturities up to 12 months, which has made the LIBOR widely used in derivatives markets. U.S. generally accepted accounting principles (GAAP) permit entities to use the LIBOR as a benchmark interest rate for their hedge accounting, including interest rate swaps and futures contracts.
In 2017, the U.K. Financial Conduct Authority, the organization that has overseen the LIBOR, announced it would not persuade nor compel financial institutions to submit rates necessary to calculate LIBOR after 2021. Eliminating the submission requirement is expected to be the end of LIBOR as we know it. After 2021, LIBOR may be fully discontinued or only partial and incomplete LIBOR rates may be available.
The loss of LIBOR may have an effect on mortgage, car, and student loans that use a variable interest rate. Borrowers often use a variable interest rate loan when they are not able to borrow funds with long maturities at a fixed interest rate. Many variable interest rate debt arrangements include a reference to a benchmark interest rate. At one point, almost 40 percent of adjustable American mortgage loans referenced the LIBOR.
A company that has a debt agreement that references LIBOR in establishing the interest rate or a penalty rate may find itself in the unfortunate position of having to renegotiate the arrangement. Having to renegotiate the debt agreement might expose a company to an increased interest rate risk that it was not anticipating. The company could also end up incurring fees associated with the contract renegotiation.
From an accounting perspective, when a modification occurs to a debt agreement, it is evaluated to determine the significance of the change in the cash flows. If the modification is significant enough, it would result in it being accounted for as an extinguishment of the old debt and creation of a new debt. A debt extinguishment may result in a gain or loss to be recognized in the income statement.
It is common for entities to enter into variable rate debt and use a derivative, such as a swap. Interest rate swaps permit companies that start with a variable interest rate to lock in to an interest rate on their variable rate debt for a set amount of time. In order to minimize the income statement fluctuations related to the derivative, a company may have applied hedge accounting. If the derivative’s critical terms, such as the interest rate on which it is based, is changed, the change may result in a de-designation of the hedging relationships. De-designation may not only result in extra accounting analysis and effort, but may also result in the volatility associated with the changes in fair value of the derivative flowing through the income statement.
Although an interest rate swap may be the most common type of hedging relationship that is affected, other hedges that reference LIBOR may be impacted as well and should be reviewed to consider the potential accounting implications of changes that may be necessary.
Contract Adjustments Will be Needed
Contracts involving financial instrument arrangements that reference the LIBOR will need to be adjusted. Regulators and financial institutions are looking for alternatives to the LIBOR. Several different benchmarks are being created to act as partial replacements for LIBOR. In the U.S., the Overnight Index Swap (OIS) based on the Secured Overnight Financing Rate (SOFR) has been promoted by the Federal Reserve Bank as a potential replacement for U.S. Dollar LIBOR rates. Aiding in its adoption, the FASB has already approved the use of the overnight SOFR. The Securities Industry and Financial Markets Municipal Swap Rate (SIFMA) is also a FASB-approved benchmark rate that could be used when applying U.S. hedge accounting standards.
Some contracts may already have a back-up provision in place about which benchmark to use in the event that the LIBOR information is not available. Even if a back-up interest rate is already written into the contract, however, the arrangement may still need to be reconfigured. A back-up provision benchmark may not be sustainable or provide the same relevancy of information as the LIBOR.
If your arrangement has a LIBOR reference, you may want to consult an accounting provider who is experienced with hedge accounting and debt extinguishments for insight about which alternative benchmark interest rate would best meet the needs of your situation.
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Published on April 08, 2019