Has your institution considered the impact of reference rate reform?
Since 2013, there has been a concerted effort to bring about reference rate reform as a result of concerns by various regulators that interbank offered rates — like the London Interbank Offered Rate (LIBOR) — have increased structural risk and declining underlying market transaction volumes, which may lend themselves to potential manipulations.
In the United States, reference rate reform has been under the guidance of the Federal Reserve Board and the New York Fed, which have set up a group of private-market participants known as the Alternative Reference Rates Committee (ARRC). The ARRC, over the course of the past six years, has worked to identify risk-free alternative reference rates to replace the U.S. dollar (USD) LIBOR, along with identifying best practices on contract modifications and creation of timelines to support an orderly adoption.
Since 2017, the ARRC has identified the Secured Overnight Financing Rate (SOFR) as the recommended alternative to the USD LIBOR and has been working on the establishment of a reliable term structure and forward-looking rate considerations under SOFR, since it lacks observable depth and liquidity under its current framework.
LIBOR has been one of most widely used benchmark interest rates in a broad range of financial instruments and other agreements.
Recent estimates place the USD LIBOR as the reference rate in over $200 trillion of active financial contracts in the cash and derivatives markets. This includes about $9.5 trillion in combined business, consumer and residential mortgage loans; floating rate notes and bonds; and investment securitizations.
The shift away from the most widely used interest rate benchmarks to alternative reference rates is a significant change for both the U.S. and global financial markets. The impact of this change is not limited to financial services companies — it will impact all companies that have LIBOR or other interbank offered rates within their financial instruments.
These financial instruments include debt agreements, investments and derivatives but may also be present in leases, compensation agreements and contracts with customers.
So the clock is winding down on the discontinuance of LIBOR and other interbank offered rates.
On March 5, 2021, the ICE Benchmark Administration, the administrator of LIBOR, announced that it will cease the publication of the overnight and 1-, 3-, 6- and 12-month USD LIBOR settings after June 30, 2023, and all other LIBOR settings after December 31, 2021. Joint interagency guidance from the Federal Reserve, OCC, and FDIC was issued in November 2020, encouraging banks to “cease entering into new contracts that use USD LIBOR as a reference rate as soon as practicable and in any event by December 32, 2021,” noting also that new USD LIBOR issuance after 2021 would create safety and soundness risks.
As a result of the reference rate reform initiatives and the pending discontinuance of LIBOR and other interbank offered rates, many institutions and financial services companies are recognizing the need to modify or amend those financial instruments or contracts which reference these benchmark rates. Preparing for the impact of rate reform will obviously depend on each institution’s identification of impacted financial instruments or contracts they have and the development of a process to negotiate what changes need to be made.
One approach being used to address this issue has been the insertion of provisions referred to as “fallback language” in new or existing agreements. These provisions specify how a replacement rate, along with other terms, will be identified once a triggering effect occurs, such as LIBOR no longer being quoted. Various industry groups have worked to develop standard fallback terms for a number of financial instruments and are recommending these terms be adopted.
From an accounting perspective, the interest rate reform process has the potential to create challenges when accounting for these contract modifications and for hedging relationships. For example, some entities may have a significant volume of contracts that will need to be modified and assessed to determine whether the modification results in the establishment of new contracts or the continuation of existing contracts for accounting purposes.
In addition, modifications related to reference rate reform for derivatives or hedged items involved in hedging relationships could result in de-designations of otherwise highly effective hedges. From a financial reporting perspective, some stakeholders are concerned about not reflecting the intended continuation of such contracts and arrangements during the period of market-wide transition to alternative reference rates. This is particularly a concern in relation to intended hedging strategies.
In response to these concerns, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2020-04, Reference Rate Reform (Topic 848), Facilitation of the Effects of Reference Rate Reform on Financial Reporting, in March 2020. This ASU, if elected, provides relief that will require less accounting analysis and recognition for modifications related to reference rate reform. Specifically, the ASU will provide the following optional expedients and specific accounting guidance for financial contracts modified because of reference rate reform:
- Contracts within the scope of Accounting Standards Codification (ASC) Topic 310, Receivables, and ASC Topic 470, Debt, may be accounted for as a continuation of the existing contract. This would be done by prospectively adjusting the effective interest rate. For financial institutions, this covers loan agreements with customers and borrowing agreements with outside parties.
- Contracts within the scope of ASC Topic 840 or 842, Leases, may be accounted for as a continuation of the existing contracts with no reassessments of the lease classification and the discount rate or remeasurements of lease payments that otherwise would be required under these topics for modifications not accounted for as separate contracts.
- The ASU provides an exception to ASC Topic 815, Derivatives and Hedging, to allow a hedging relationship to continue without de-designation for certain changes in the critical terms of a hedging relationship. An entity may change the reference rate or other contractual terms of a hedging instrument, a hedged item or a forecasted transaction designated in a fair value hedge, cash flow hedge or net investment hedge, as applicable, so long as the changes are due to reference rate reform.
- For other ASC topics or industry subtopics, the ASU includes a general principle that entities may consider in-scope contract modifications as events that do not require contract remeasurement or reassessment of previous accounting determinations.
It’s important to note that to qualify for the optional expedients for contract modifications, other terms being concurrently modified need to be related to the replacement of a reference rate because of reference rate reform. The ASU includes guidance and examples for identifying when changes to the terms of the contract are related to the replacement of a reference rate and are eligible for the optional expedients. In addition, all elected expedients must be applied consistently to all eligible contract modifications in the ASC topic or industry subtopic.
The guidance found in ASU 2020-04 is effective for all reporting entities immediately upon issuance on March 12, 2020, and may be adopted prospectively in a reporting period subsequent to the issuance date. However, the optional expedients relief under this guidance is only temporary and can be applied only through December 31, 2022, except for certain optional expedients elected for hedging relationships.
How Wipfli can help
Has your institution begun the process of evaluating what impacts reference rate reform will have on its current and future financial instruments or contracts? Getting familiar with the ARRC’s transition plans and the expedient relief options outlined in FASB’s ASU 2020-04 is an important component in helping your institution work through the reference rate reform impact process. Contact our team today if you have any questions or need additional information related to reference rate reform.