(Second of two parts)
In the first part of this article, we highlighted the current state of Interbank Offered Rates (IBORs), the factors behind the shift from IBORs to Alternate Reference Rates (ARRs), and the top 10 challenges to be faced in transitioning to the ARRs. In this second part, we will delve into the key operational, financial and accounting considerations that come along with the imminent discontinuation of IBORs.
It is expected that the broad impact of transitioning to ARRs will be felt not just by banking and capital market organizations, but also by corporates with significant exposures to IBOR-linked instruments. This impact will cut across various functions within an organization, including treasury, legal, finance and risk. Given this, it is imperative for market participants to quickly assess the cross-functional implications of the transition to their businesses and clients. Having an awareness of these implications early on will help an organization plan for an efficient transition. Here are some of the key considerations for organizations before the IBOR reform is implemented:
Determining your exposure to IBOR — Developing a detailed inventory of IBOR-linked products and contracts will be cumbersome for many organizations with existing financial contracts that are not digitized. The organization will have to ensure that relevant contract terms, including any fallback provision, are captured so that all legal and financial risks are determined.
Contract renegotiations — IBOR-linked products and contracts may need to be modified and renegotiated. While the International Swaps and Derivates Association provides protocols to facilitate amendments to contracts between counterparties, having a huge number of derivative contracts to be amended can be a tedious task. For cash products, the renegotiation may be more burdensome due to the non-standard nature of most of the contracts. Multilateral negotiations will also be required for bonds, syndicated loans and other securitized products. It will also be necessary to establish governance processes and controls to avoid any financial, legal and operational risks.
Impact on IT systems and infrastructure — The shift to ARRs will require changes to various platforms (e.g., valuation, trading and risk management systems) within the organization’s IT systems.
Recalibration or redevelopment of models — Organizations need to build an inventory of all its pricing, valuation and risk models that use IBORs as an input and assess the need for recalibration or redevelopment. Any change in the models will also impact the front (in terms of pricing strategy and new product offerings) and back-office processes of the treasury function and will warrant an update of the organization’s risk management strategy.
Accounting and hedging — The transition to IBOR will have a significant impact on various aspects of accounting, more notably on the application of hedge accounting and derecognition assessment for any contract modification due to changes in reference rates. Although amendments to IAS 39 Financial Instruments: Recognition and Measurement and IFRS 9 Financial Instruments are underway to address some problematic hedge accounting issues pre-IBOR transition, financial reporting issues post-IBOR transition are still to be dealt with by the International Accounting Standards Board (IASB). The pre-IBOR transition issues covered by the proposed amendments to IAS 39 and IFRS 9 relate to the assessment of the probability of the hedged forecasted IBOR cash flows occurring, assessment of effectiveness of hedging relationships and the immediate release of any amount lodged in equity to profit or loss if hedged IBOR cash flows will no longer occur.
WHAT ORGANIZATIONS SHOULD START DOING NOW
Given the various considerations discussed above and the impending completion of the IBOR reform by local jurisdictions, there is a need for organizations to plan and prepare for a smooth transition to ARRs. As discussed in a recent EY publication titled How will you respond to IBOR transition (https://www.ey.com/Publication/vwLUAssets/EY-end-of-an-ibor-era/$FILE/EY-end-of-an-ibor-era.pdf), organizations must establish an IBOR transition program as a necessary foundation upon which they can plan their transition strategy and implementation programs. Here are recommended steps in establishing an IBOR transition program according to the EY report:
Assemble a broad-based IBOR transition team — Mobilize a formal IBOR transition program team with a strong governance framework and senior leadership appointed to oversee and report progress to relevant executive committees and the board. This program team should be cross-functional in nature, with business leaders represented from inception.
Conduct a comprehensive impact assessment — The impact assessment should cover all areas of the business that are exposed to IBOR. This would include:
(1) product assessment — categorize and quantify financial IBOR exposure by various parameters, including maturity, optionality, counterparty, client segment, business and jurisdiction;
(2) legal contract assessment — extract and analyze the contractual language of the impacted products with a priority on positions that are due to mature beyond 2021;
(3) risk assessment — analyze the potential impacts of transitioning to ARRs on the risk profile and financial resources of your organization;
(4) operational assessment — identify impacted areas, including systems, models and processes that are linked to current IBORs; and
(5) inventory management — establish and maintain an inventory of products and contracts linked to IBORs across jurisdictions.
Develop a transition roadmap — A comprehensive implementation roadmap is needed for prioritized initiatives, including key workstreams, projects, milestones and ownership. A strategy for educating and communicating with both internal and external stakeholders should also be addressed, including clients, technology vendors, regulators and industry bodies.
Launch the formal IBOR transition program — Publish a multi-year enterprise-wide transition program, including a program charter, a stakeholder map and resourcing requirements.
As the pace of IBOR transition picks up, complacency will be detrimental to organizations with significant exposure to IBORs. Considering the complexity and wide-ranging scope of the transition, these organizations should initiate steps to prepare and make the most out of this exercise. A “wait and see” approach to implementation will not work with the overwhelming challenges that are expected to emerge when the IBOR is discontinued. At this point, an organization that can get ahead of the curve will have the advantage of identifying early market opportunities with the new ARRs.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co.
Janice Joy M. Agati and Redgienald G. Radam are Senior Directors from SGV & Co.’s Financial Service Organization service line.