December 10, 2019
LIBOR Phase-Out Expected After 2021 – Trillions of Dollars Exposed
LIBOR, the long-standing interest rate benchmark used in many commercial contracts is expected to be discontinued after year-end 2021. LIBOR is based on the cost of short-term unsecured loans between leading international banks. Its discontinuance is due to the unreliability of the index and a tainted history of manipulation. Since the financial crisis, the supporting market activity has diminished, which presented opportunities for banks to report false rates to hide liquidity issues or entice investors to generate profits. Enlight of the marred history and pending phase-out, stakeholders have questions and concerns given that LIBOR exposure is in the hundreds of trillions of dollars in the U.S. alone.
The U.S. Federal Reserve established the Alternative Reference Rates Committee (ARRC), a working group focused on transitioning from LIBOR to the Secured Overnight Financing Rate (SOFR), a benchmark rate used in a larger and more liquid population of observable transactions. The SOFR comes with its own less severe concerns, including limited historical data, lack of comparable duration rates, and potential for volatility. However, other acceptable reference rates are available. In some cases, contracts already include “Fallback Rates,” such as Prime or the U.S. Treasury Bill, in the event LIBOR, is no longer available. The looming questions are now:
- What is the impact on current accounting practices?
- Will contracts need to be renegotiated?
- Are there expedient methods for transition being considered?
On November 13, 2019, FASB approved an accounting standard update (ASU) to provide temporary accounting relief during the transition from LIBOR. The ASU will provide optional expedients and exceptions for applying GAAP to contracts and transactions that are anchored to LIBOR. Examples include promissory and surplus notes, lines of credit, loans, premium financing, and derivative contracts. Receivables and debt contracts will be accounted for by prospectively adjusting the interest rate. Leases will be accounted for as a continuation with no remeasurement or reassessment. Similarly, derivatives and hedges will not require reassessment and will still apply hedge accounting. The final ASU is expected to be issued in early 2020. The amendments will be effective upon issuance and apply only to contract modifications, and hedging relationships entered into or evaluated before December 31, 2022.
The NAIC is monitoring FASB’s actions and is expected to meet once the final ASU is issued. They will likely request an interim exposure to be consistent with GAAP.