IBOR

IBOR Reform – What in the heavens is that?

After reading the heading, some of you may be asking what is IBOR?

Well, IBOR stands for Interbank Offered Rate which is a benchmark interest rate. There are number of IBORs in the world today including well known ones to us such as LIBOR (London Interbank Offered Rate), Euribor (Euro Interbank Offer Rate) and MIBOR (Mumbai Interbank Offer Rate). Such rates include credit risk of banks/ financial institutions offering such rates.

Now, many of you might be asking, okay, I know what IBOR stands for but why should I worry about IBOR reform?

IBOR reform is important as most regulators are moving away from IBORs. In fact, most IBORs including LIBOR and Euribor are expected to be phased out by the end of 2021 and replaced with other benchmark rates such as SOFR (Secured Overnight Funding Rate) for US Dollar denominated instruments, SONIA (Reformed Sterling Overnight Interest Average) for British Pound denominated instruments, and €STR (Euro Short Term Rate). Such rates are usually risk-free rates as these are based on government bond rates.

Regulators have become uncomfortable with IBOR because of because they are based on trader quotes rather than actually observed rates. Regulators’ discomfort significantly increased after the LIBOR rate fixing scandal came to light in 2012. The traders were colluding with each other to rig LIBOR and thus to make profits.

Now, some of you might say, the IBORs are phasing out, so what?

Well, it should matter to all those who are involved with companies which have lent or borrowed money in foreign currencies. This will particularly have significant impact on banks and other financial institutions who borrow and lend money in foreign currencies. All such companies, whether following Indian Accounting Standards (“Ind AS”) or Accounting Standards (“AS”), will be impacted. However, banks and financial institutions may also have to follow any guidelines issued by the Reserve Bank of India in this respect.

It should be noted that a vast majority of financial instruments in the world (especially lending/ borrowings) are linked to IBORs. PwC[1] has indicated that financial instruments of over 350 trillion US Dollars are linked to LIBOR alone.

In the Indian context, most of the lending/ borrowings denominated in foreign currency are linked to IBOR, mostly to LIBOR. These could be plain vanilla loans, bonds, debentures, and convertible instruments such as foreign currency convertible bonds (“FCCBs”). Also, other financial instruments such as supplier’s credit and interest-bearing advances against contracts which are in foreign currency may also be linked to IBOR.

The first impact of IBOR reform is at business and finance/ treasury level.

Since, interest rates in current contracts are linked to IBOR, the interest rate clauses in all lending/ borrowing agreements will become inoperative when respective IBORs are phased out. Hence, all lenders and borrowers need to renegotiate their contracts to move away from IBOR and link the interest rates from the current IBOR to another applicable benchmark rate. The lenders need to ensure that their interest income on lending does not decrease while the borrowers need to ensure that the interest expense on their borrowings does not increase.

In fact, it is quite possible, that lenders may already have reached out to borrowers for renegotiating the agreements. Also, some lenders have already started to include clauses to cover other benchmark rates on phasing out of applicable IBOR in their lending contracts.

Second impact is at the accounting level.

There are two accounting impacts – first relates to modification of the lending/ borrowing contract and second relates to hedge accounting if the lender/ borrower has a hedge in respect of foreign currency lending/ borrowing, particularly against the interest rate, and follows hedge accounting.

A change in benchmark rate in respective contracts will result in modification of respective financial instrument contracts. While we have no guidance regarding modification of financial instruments in accounting standards included in the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as “AS’), there is extensive guidance in this regard in Indian Accounting Standard 109, Financial Instruments (Ind AS 109) included in the Companies (Indian Accounting Standards) Rules, 2015.

Ideally, companies following AS should also follow the accounting provided in Ind AS 109 to account for the modification of lending/ borrowing contracts, as applicable. However, I hope that the Institute of Chartered Accountants of India (“ICAI”) will issue an advisory on this in due course.

Under Ind AS 109, a gain/ loss on modification needs to be computed and taken to statement of profit and loss when the modification occurs. International Accounting Standards Board (“IASB”) has issued an exposure draft, as part of its phase 2 of the project regarding IBOR reform and its effect on financial reporting,  to amend IFRS 9, Financial Instruments and IFRS 4, Insurance Contracts  to provide some relaxations on financial instruments modification accounting and hedge accounting once an IBOR is replaced with another benchmark rate in financial instrument contracts. It is expected that the final amendments will be issued sometime in third quarter of 2020.

We can expect similar amendments to be made to Ind AS 109 and Ind AS 104 at an appropriate time and also to the Guidance Note on “Accounting for Derivates” (“GN”) issued by ICAI which is applicable to entities which are preparing AS compliant financial statements.

Now coming to the impact of IBOR reform on hedge accounting.

Replacement of benchmark with other interest rates may lead to failure of certain hedges to qualify for hedge accounting. Consequently, hedge accounting will have to be discontinued as of today.

IBOR Reform will affect companies in all industries that have applied hedge accounting for IBOR-related hedges, such as hedges of loans, bonds and borrowings with instruments such as interest rate swaps, interest rate options, forward rate agreements and cross-currency swaps.

This can happen when future interest cash flows that depend upon an IBOR (for example, future LIBOR-based interest payments on issued debt hedged with an interest rate swap) are no longer “highly probable” beyond the date at which the relevant IBOR is expected to cease being published.

Secondly, both Ind AS 109 and the GN require a forward-looking prospective assessment in order to apply hedge accounting. Ind AS 109 requires there to be an economic relationship between the hedged item and the hedging instrument, whereas GN requires the hedge to be expected to be highly effective. Given the uncertainties arising from IBOR reform, including when IBORs will be replaced and with what rate(s), this might become difficult to demonstrate currently. This could give rise to hedge ineffectiveness in the prospective assessment, in particular where the replacement of the benchmark rate is expected to occur at different times in the hedged item and the hedging instrument. The uncertainties described above in the context of prospective assessments could also affect GN’s retrospective effectiveness requirement.

Thirdly, in some hedges, the hedged item or hedged risk is a non-contractually specified IBOR risk component. An example is a fair value hedge of fixed-rate debt where the designated hedged risk is changes in the fair value of the debt attributable to changes in an IBOR. In order for hedge accounting to be applied, both Ind AS 109 and GN require the designated risk component to be separately identifiable. Given the uncertainties arising from IBOR reform, this might cease to be the case.

However, the good news is that IASB, as part of Phase 1of the project regarding IBOR reform and its effect on financial reporting, has issued certain amendments to IFRS 9 and IFRS 7, Financial Instruments Disclosures, providing  reliefs to hedge accounting in the period before the reform.

These amendments are effective from accounting periods beginning 1 January 2020 with earlier application permitted.

We can expect similar amendments in Ind AS 109 and Ind AS 107 to be issued by Ministry of Company Affairs in the near future. ICAI had already issued an exposure draft of the proposed amendments to Ind AS 109 and Ind AS 107 in 2019. We also hope that ICAI will provide similar reliefs in the GN.

These amendments provide as follows:

  • Firstly, the amendments require an entity to assume that the interest rate on which the hedged cash flows are based does not change as a result of the reform. Hence, where the hedged cash flows may change as a result of IBOR reform (for example, where the future interest payments on a hedged forecast debt issuance might be SONIA + X% rather than GBP LIBOR + Y%), this will not cause the ‘highly probable’ test to be failed.
  • Secondly, the amendments provide that an entity assumes that the interest rate benchmark on which the cash flows of the hedged item, hedging instrument or hedged risk are based is not altered by IBOR reform and hence the economic relationship and hedge effectiveness is not affected.
  • Thirdly, under the amendments, where only a risk component is hedged, the risk component only needs to be separately identifiable at initial hedge designation and not on an ongoing basis. In the context of a macro hedge, where an entity frequently resets a hedging relationship, the relief applies from when a hedged item was initially designated within that hedging relationship.
  • IFRS 7 has been amended to require disclosure of the nominal amount of hedging instruments to which the reliefs are applied, any significant assumptions or judgements made in applying the reliefs, and qualitative disclosures about how the entity is impacted by IBOR reform and is managing the transition process.  

I hope I have provided some clarity on the issue. Entities which have financial instruments (loans given/ borrowings, etc.) in foreign currencies should start a dialogue with their counterparties, if not already done so. Also, entities may consult their auditors/ accounting experts on accounting implications arising from IBOR reform based on facts and circumstances in their case.

[1]Source: https://www.pwc.com/gx/en/industries/financial-services/publications/libor-reference-rate-reform.html