03 May 2019

Financial Times: Accounting body proposes relief on Libor transition

The International Accounting Standards Board will publish proposals offering relief on the treatment of old Libor-type benchmarks and newer ones, such as Sofr, the US benchmark.

If adopted, the move by the IASB, which sets the accounting rules followed by 144 countries, would help banks and others avoid penalties as they take on the tricky task of transitioning away from scandal-tainted benchmarks.

Global regulators want the market to scrap Libor and instead price thousands of loans, mortgages and derivatives contracts using overnight lending rates, which are based on transactions, by the end of 2021.

The Libor rate, which measures the cost of unsecured borrowing between banks for a specific period, is made up largely of banks’ estimates. That methodology has been problematic, but the rate remains embedded in contracts ranging from mortgages to banks’ regulatory capital. More than $370tn of deals are tied to it.

Shifting to a new rate is a complex task; transactions referring to new rates accounted for less than 3 per cent of the notional derivatives market in the first quarter of this year, according to ISDA, a trade body.

The IASB’s move would temporarily resolve an accounting problem. At present, banks and companies can use a technique known as hedge accounting to minimise the impact on their balance sheets if a product, such as a loan, and its risk-offsetting swap, cancel each other out. But a change in the terms of a derivative contract could mean the swap is terminated, leaving both parties stumping up more capital to find new hedges.

The IASB said that its existing standards required companies to use forward-looking information to apply hedge accounting — a conundrum given there is little agreement about when the current benchmarks will be replaced, or even which interest rate would be used.

Reform of Libor has been further complicated because Libor and the newer overnight rates do not always move in concert. The spread, or the difference between the two rates, can sometimes rise to as much as half a percentage point in volatile periods. Before the financial crisis it was about a tenth of a percentage point, according to EY, the professional services firm.

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