Following the ‘Dear CEO’ exercise of September 2018[1], the UK’s FCA and PRA published the key findings from the responses received[2], in June 2019. This has been followed with two speeches, where a change of tone has been recognizable. Firstly, there was the speech from Andrew Hauser of the Bank of England, emphasizing the benefits of transitioning to a risk-free rate, in June 2019[3]. Then there was the speech from Andrew Bailey of the FCA in July 2019[4], which also emphasized the benefits of transition, as well as the downsides of not transitioning well before the LIBOR end date of 31st December 2021.
Underpinning this change in tone, is strong encouragement for market participants to use SONIA compounded in arrears as their replacement rate for GBP LIBOR, and not to wait for the development of a term risk free rate.
The benefits to the markets as a whole are certainly compelling (see both speeches). And, turning to corporates, Andrew Bailey points out in his speech that Associated British Ports have recently successfully negotiated with bond investors a transition from GBP LIBOR to SONIA, compounded in arrears, for their GBP 65 million, floating rate bond issue[5], which he suggests could be used as a model for other market participants to achieve the same.
However, a fundamental challenge for many corporates is that LIBOR is a forward-looking term rate, whilst the RFR is overnight and backward looking. This means that, for legacy transactions, there will need to be both a term and spread adjustment applied to the RFR to ensure that it mirrors LIBOR as closely as possible so ensuring that existing contracts continue to function as intended when they were put in place.
The latest question is whether it is appropriate to leave the pricing of this adjustment to market participants?
There appear to be at least two key risks to a market led approach:
Firstly, if the LIBOR to risk-free rate adjustment negotiated with lenders differs to the rate applied to related derivatives, then there would appear to be a very real risk that a permanent interest flow mis-match would occur, which could negatively impact hedge accounting, cash flow, covenants and reported results.
Secondly, and more worryingly for corporates, there have been reports that some lenders are using the transition process as an opportunity to entirely renegotiate and re-price loans (and in some cases, to exit them entirely). Unsurprisingly the loans apparently most at risk are those that are currently unprofitable for the lender… Such ‘renegotiations’ will almost certainly result in increased costs of borrowing causing real economic harm. If proved accurate, such behaviour would be particularly ironic, given the mis-conduct issues that have been linked to LIBOR in recent years.
The official sector in the UK is alive to conduct risk – and has emphasised in recent speeches that they will be watching carefully. However, this is a global risk as USD, EUR etc. transition from local IBORs.
A more pro-active approach from the regulator in the establishment of a IBOR to risk-free rate conversion mechanism, and their engagement to remove any suspicions of lenders using the situation to their own advantage may be welcomed by the real economy who feel that, in general they have very little negotiating power in this process.
The ACT is currently seeking views on this subject from its members, as it deliberates whether it should write a formal letter to the regulator requesting more formal engagement.
If you have experience of any of the issues raise in this note, or simply have a constructive thought to add to the debate, please share these with the ACT via email at technical@treasurers.org.
(With thanks to James Leather, FCT in drafting this note)
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[1] whereby the UK’s Financial Conduct Authority (the FCA) and PRA (Prudential Regulation Authority) wrote to CEOs of major banks and insurers supervised in the UK asking for details of the preparations and actions they are taking to manage transition from LIBOR to alternative interest rate benchmarks, to gain assurance that the risks associated with this transition were understood and that appropriate actions were being taken so that firms have transitioned to alternative rates by the end of 2021
[4] https://www.fca.org.uk/news/speeches/libor-preparing-end
