What is LIBOR?
The London Interbank Offered Rate (LIBOR), an average rate calculated from estimates submitted by leading banks, has long been the go-to average rate at which certain banks could borrow in the interbank market. Duration ranges from overnight to 12 months. In 2014, the Financial Stability Board (FSB) set a series of recommendations for strengthening existing benchmarks for key interbank offered rates (IBORs) and began promoting adoption of risk-free reference rates (RFRs).
Why is Replacement Needed?
- Durability: The alternative RFRs selected so far by jurisdiction working groups are based on robust, liquid underlying markets, making them much more durable.
- Appropriateness: Jurisdiction working groups have determined that alternative RFRs represent a more appropriate benchmark for products and transactions that do not need to incorporate the credit risk premium embedded in the IBORs.
- Risk Reduction: Currently price alignment interest (PAI) for cleared transactions and discounting is typically based on overnight rates, while interest rate derivatives primarily reference IBORs. Alternative RFRs are expected to be used in both instances, which will reduce basis risk.
Financial institutions should be proactively working to transition away from LIBOR, as regulators have made clear. A starting point for a LIBOR strategy will begin with the document population that defines a bank's LIBOR terms. Contract conversion will require a complete understanding of existing contract population, relevant document types, linking of amendments and applicable clauses. Contractual triggers and “if then” scenarios must be understood before conversion to alternative RFR. To appropriately manage risk, duration and hedge effectiveness of the selected alternative RFR should be examined and understood. Technology (data repositories, providers, middleware, core systems) and data will be heavily impacted so action plans should be implemented to ensure the data requirements of the RFR are captured and managed effectively. Day one balance sheet impacts, fair value assessment, hedge accounting, accounting classification, and cash products will all be affected by the change to an alternative RFR. Fair value changes may impact taxation of firm. Contractual renegotiation and/or closeout may accelerate tax recognition.
Protiviti’s subject matter experts possess the skills and required expertise to help organizations face the major challenges of LIBOR replacement proactively and ensure a well-managed, risk-informed transition to alternative RFRs.