Breaking up with LIBOR - The CFO, the Corporate Treasurer and the risk of inaction

Stefan Wüest Director Treasury Solutions, PwC Switzerland 31 Jan 2019

Our experience shows that companies are commonly exposed to a variety of risks resulting from the discontinuation of LIBOR, including unfavourable contract conditions, operational risks, higher P&L volatility, and tax risks. CFOs and Corporate Treasurers are now encouraged to begin transition planning.

The questions

On 14 November 2018, the Financial Stability Board published a progress report stating that ‘transition is necessary’ for LIBOR-linked contracts prior to the rates’ discontinuation after 2021. This affects contracts with hundreds of trillions of dollars in notional volume which are LIBOR-linked and with maturities running beyond 2021. The transition to alternative benchmarks means that market participants need to begin remediation efforts now.

If you are the CFO or treasurer of your organisation, consider the following: Have you assigned responsibility to a project manager to identify your group’s exposures to LIBOR-linked contracts? Are you aware of the current fall-back provisions that will be triggered should your group fail to adjust all contracts in time? Is your group continuing to enter into new LIBOR-linked contracts, despite being aware that such reference rates will be discontinued after 2021? Do you know the average basis spread between SARON and CHF-LIBOR, or between SOFR and USD-LIBOR? Do you have sufficient data to coherently renegotiate contracts at advantageous terms?

The background

The transition away from LIBOR can be traced back to July 2014, when the Financial Stability Board (FSB) published a report calling for reform. The report shone a spotlight on the vulnerability of LIBOR to manipulation, given that such rates are based on submissions by a very limited number of contributing panel banks. In addition to that, LIBOR is meant to represent interbank lending rates on an unsecured basis. As the overwhelming majority of interbank lending is conducted on a secured basis, LIBOR has increasingly come to represent the panel banks’ best estimate of interest rates which are seldom used in practice.

In response, national working groups were established to provide recommendations to strengthen the existing benchmark interest rates around the world, and to replace LIBOR with alternative reference rates (so called ‘nearly risk-free rates’ or RFRs) which are based on observable market transactions. The aim was to create benchmark rates that are more robust and resilient to abuse.

Panel banks will no longer be compelled by regulators to submit LIBOR estimates beyond 2021. Consequently, LIBOR rates are not expected to be published beyond this date. As of year-end 2018, alternative overnight reference rates have been freely available in USD, CHF, GBP, and JPY. The EUR RFR remains under development, with the European Central Bank expected to start publishing the Euro short-term rate (ESTER) by October 2019 at the latest.

OTC derivative markets using the new benchmark rates (except for EUR) are already building in depth and liquidity. As a safeguard, the International Swaps and Derivatives Association (ISDA) is developing language for standard contractual fall-back provisions that may be used when companies fail to update contracts in time. Furthermore, the International Accounting Standards Board (IASB) is in consultation with market participants to define how international accounting rules (IFRS) are likely to be impacted by the transition away from LIBOR, notably in the context of the rules on hedge accounting.

LIBOR replacement rates

Existing LIBOR rate	Proposed alternative benchmark	Borrowing type	Regulatory working groups
EUR LIBOR	Euro short-term rate (ESTER)	Unsecured	European Working Group
USD LIBOR	Secured overnight financing rate (SOFR)	Secured	Alternative Reference Rates Committee (ARRC)
GBP LIBOR	Reformed Sterling overnight index average (SONIA)	Unsecured	Bank of England's Working Group on Sterling Risk Free Reference Rates
CHF LIBOR	Swiss average rate overnight (SARON)	Secured	National Working Group on Swiss Franc Reference Rates
JPY LIBOR	Tokyo overnight average rate (TONAR)	Unsecured	Japanese Study Group on Risk Free Reference Rates

The solution

Corporate treasurers have been aware for quite some time that the discontinuation of LIBOR would have a considerable impact, with hundreds of trillions of dollars in contracts (notional volumes) requiring adjustments by the end of 2021. Not all CFOs and treasurers, however, have grasped the risks posed by an unprepared transition. Our experience shows that companies are commonly exposed to a variety of risks resulting from the discontinuation of LIBOR, including:

Unfavourable contract conditions	Discrepancies between current contractual fall-back provisions on financial instruments and the default fall-back provisions under future ISDA protocol Higher future funding costs after the renegotiation of the spread above benchmark
Operational risks	Changes to data feeds into treasury management and ERP systems Disruption to system-driven calculations including interest income & expense, valuations, and hedge effectiveness testing Adjustments required for significant operational documentation, including ISDA protocol, banking master service agreements, collateral agreements, securities lending and repo facilities, cash pooling and intercompany lending facilities, accounting policy and treasury policy documents, hedge accounting documentation, and some lease agreements Disruption to spreadsheet modelling, including some cashflow forecasting, management compensation and hedge effectiveness models Uncertainty when it comes to future interest payments in currencies for which a retrospective term rate structure is elected Impact on calculation of distributable earnings, and thereby on cash remittances from affiliates
Higher P&L volatility	Creation of new basis risk Day-1 P&L shock (i.e. value transfer) on deal adjustments and debt modifications Disruption of financial risk management structures and hedging strategies Disruption of hedge accounting relationships
Tax risks	Uncertainty as to how updated contracts will impact the rates used in cash pooling and intercompany lending facilities Loans with long maturities require benchmarking and re-pricing Loss of tax efficiency of the group’s funding structure, if transfer pricing is challenged by tax authorities Invalidation of ATAD II (or other) grandfathering rules

Key findings

The discontinuation of LIBOR has manifold consequences:

Traditional LIBOR rates are expected to be discontinued after 2021.
The replacement benchmark rates are more robust and less exposed to abuse.
The pervasiveness of LIBOR’s use in corporate treasuries, and in financial contracts more broadly, leads to far-reaching adjustments being necessary.
Reluctance to mitigate exposures to LIBOR will put your company at risk, at potentially significant cost.

Treasurers and CFOs now need to develop a roadmap towards the post-LIBOR world. If your organisation has not yet completed its transition roadmap, our PwC experts are available to assist you.