Saying goodbye to Libor, the world’s most valuable benchmark

By Kuntal Sur
Partner, Fin Services, PwC India

After being the global benchmark for lending and borrowings for over 33 years, Libor (London Inter-Bank Offered Rate), published by the Financial Conduct Authority (FCA) of UK, is going to stop from December 2021. Over $350 trillion worth of contracts across the globe are pegged to Libor which is the key interest rate benchmark for several major currencies. Many current contracts would extend beyond 2021. The transition to alternative reference rates will involve considerable efforts for Libor users for impact assessments, amending contracts and updating systems.

IMPACT ON FINANCIAL INSTITUTIONS


Institutions have to identify legacy contracts linked to Libor and carry out their vulnerability assessments, like fair value changes for foreign currency loans, impact on product prices like syndicated loan books, derivative contracts and hedges need to be fair valued. The impact of changes in fair value need to be estimated from accounting and valuation perspectives. There will also be an impact on inter-bank markets through Mifor (Mumbai Interbank Forward Outright Rate) rates, which is used for forward premium calculation and swap rates. Mifor rates for different tenors are calculated using the rolling forward premia in percentage term and the USD Libor for the relevant tenor.

For corporate sector, in particular infrastructure and housing finance, where external commercial borrowings are for a longer term, these contracts need to be revaluated while including the impact of shifting to a new benchmark and the impact on hedges and hedge accounting.

THE NEW BENCHMARK

It is still unclear what will replace LIBOR. In April 2017, the Risk Free Rate Working Group in the UK selected the Sterling Over Night Index Average (SONIA) as its proposed alternative benchmark. In June 2017, the US Alternative Reference Rates Committee chose a broad Treasuries repo rate as their preferred risk free rate (RFR). Now known as SOFR (the Secured Overnight Financing Rate), it has been officially published since early April 2018. The biggest challenge with RFRs that, currently they have no term structure and some of the proposed alternative RFRs (including SOFR) are secured and as a consequence, unlike Libor, do not bear a credit spread. These aspects will need to be considered when preparing for the transition. It has been tough to agree on a common approach with respect to standard methodologies for pricing the credit and term risk to be added to the risk-free rate. To do away with these challenges, the ICE Benchmark Administration, has proposed switching to the US Dollar ICE Bank Yield Index (IBYI), which competes with SOFR.

LIBOR TRANSITION

Most leading banks and institutions have started their LIBOR transition by forming a steering committee, which has representatives from different teams like loan syndication, treasury, risk management, technology, legal and compliance. The committee evaluates each business expected to be impacted by the transition. The biggest challenge in impact assessment is to identify alternative benchmarks and create a term structure out of it. The second important task is to review the current set of contracts and divide them into different buckets based on the remaining maturity. Longer term contracts need to be either terminated/unwound or moved to new benchmark(s) and transiting into a new set of rules before December 2021. Once the impact assessment is done, the implementation will revolve around how to remediate business risks, legal and compliance risks, fair value impact of derivatives and loan portfolios linked with foreign currencies, data and system modifications, accounting remediation and tax and transfer pricing impacts.