Libor transition – what are you waiting for?

14 August
Image of a bank exterior, focusing on the word ‘BANK’ above the entrance

A recent ACT webinar lifted the lid on how banks are preparing for the move away from Libor. Sarah Boyce explains the implications for treasurers

The ACT hosted a webinar in mid-July that looked at Libor transition through a different lens – that of the banks. There were some particularly interesting issues relevant to corporates raised during this conversation and we would encourage you to listen to the whole recording, which can be found here.

This webinar focused predominantly on transactions that currently reference Libor – and what needs to happen to them. These legacy contracts – or back book as it’s referred to – potentially cause the largest problem for corporates as they include a high proportion of corporate loans (both bilateral and syndicated) or longer-dated transactions traditionally used by sectors such as housing and utilities.

We started the webinar by discussing what Libor transition means for banks in practice. And actually, it’s pretty fundamental as they need to revisit their entire bank funding and treasury strategy. This is central to how a bank operates and might explain why it’s taking them so long to begin offering solutions to their clients…

The ‘Dear CEO’ letter sent out in the UK by the Financial Conduct Authority (FCA) to the largest financial institutions late last year (and which the FCA and Prudential Regulation Authority are keen to emphasise should be considered by all regulated firms) certainly seems to have energised their response – although of course the banks have already been working on transition for some considerable time and have established large project teams to manage through the process. (First question for corporates is whether they have a project team for this, particularly as the impact is far beyond treasury.)

So, listening to the bankers, what were the top takeaways – and what do they mean for corporates?

 

1. The scale of the challenge and what transition means in practice for contracts referencing Libor

A key exercise that the banks have had to complete is an assessment of their existing Libor book (a task which, in broad terms, corporates also need to undertake). Banks are looking at:

  • maturity profile (ie what contracts run past the end of 2021); and
  • whether contracts envision a permanent replacement of Libor and, if not, how to implement replacement fallback language.

In addition to the above, corporates might want to:

  • review legal documentation to identify which contracts may need to be renegotiated in the event of Libor no longer being available. This may include commercial contracts, not exclusively financial markets (treasury) contracts;
  • identify any internal and external counterparties that may be impacted – this is not only banks;
  • identify processes that need changing (for example, charging of interest on overdue receipts);
  • understand the impact of any change on accounting and valuations – hedge accounting may be at risk; and
  • talk to your tax departments/advisers (including any transfer pricing team), controllers, procurement, credit and any joint ventures that have their own financing (such as project finance arrangements) to identify the issues.

The scale of the challenge for any firm that references Libor in financial or commercial contracts or uses it as a valuation tool (for example, in accounting, business plans or budgets) must not be underestimated. Every instance where Libor is referenced in the organisation needs to be identified and a decision taken about what to replace it with – and that is not a straightforward decision.

For example, in late-payment clauses in commercial contracts it may be fine to move to referencing UK base rate (or a local currency equivalent) as it is generally the margin over the benchmark that is punitive.

But base rate may not be appropriate for a commercial loan where there is a related hedging transaction.

2. What are the banks doing to assist treasurers with preparations for transition?

 
Client engagement

All of the major banks in the UK are now running customer engagement programmes to inform their clients about Libor transition generally, identify the issues that clients might want to focus on and offer solutions (this third point is somewhat behind the other two, but should start to catch up over the coming months as new products are brought to market).

Management of conduct risk

Conduct risk is broadly defined by the FCA as any action of a financial institution or individual that leads to customer detriment or has an adverse effect on market stability or effective competition. The FCA has deliberately set out a very wide definition of conduct risk, leaving the onus on financial services firms to prove how they are protecting customers. This is in recognition of the perceived imbalance of power between banks and their clients in this process.

 

3. What can treasurers do now?

In preparation for transitioning legacy transactions, treasurers should focus on infrastructure.

Firstly, systems:

Treasury management systems (TMS) providers are working on providing solutions that will enable the booking of transactions that have interest that compounded in arrears (that being how many of the replacement risk-free reference (RFR) benchmarks are expected to work), but they cannot finalise system changes until there is greater clarity around market conventions.

Corporates should talk to their TMS providers (remembering that most TMS vendors will only provide updates for the later versions of their software) but also consider how they might need to resource and time any updates to their systems. IT consultants will likely be in high demand as transition picks up speed, and many corporates have periods in the year where systems updates are not permitted (for example, over year end).

Secondly, the mechanics of how to transition transactions from Libor to a replacement benchmark – specifically documentation – must be addressed.

This can be split into:

  • legacy transactions (that reference Libor) but do not foresee permanent discontinuation of Libor in the documentation; and
  • newer transactions that still reference Libor but have replacement (fallback) language that works in the event of a permanent discontinuation of Libor. Generally, these are transactions undertaken in the last few years, but this will be dependent on exactly what language has been adopted in the documentation.

Re-documenting transactions is not straightforward as Libor has both term and bank credit factored into it unlike an RFR so a credit spread adjustment will also be required – and how that’s to be calculated is still something of an unknown.

As is the case with IT consultants, lawyers are another group likely to be in demand as transition builds pace, so it’s worth talking to yours sooner rather than later.

So, to summarise, while it may still feel like Libor transition is ‘a long way off’, or ‘may never happen’, neither is accurate. Corporates need to follow the banks’ lead and start to engage now in the process. If nothing else, they need to make sure that they are prepared for when things pick up speed.

 

About the author

Sarah Boyce is associate director, policy and technical, at The Association of Corporate Treasurers

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