November 8, 2018
November 8, 2018
The phrase “LIBOR transition” doesn’t elicit more than a yawn from most corporate treasurers.
But how about this: “the terms on your debt maturing after 2021 are going to change, whether you like it or not.”
That is precisely the scenario in view as regulators phase out the London Interbank Offered Rate, or LIBOR, by the end of 2021.
Known as the “world’s most important number,” LIBOR has more than $240 trillion linked to its daily fluctuations according to Oliver Wyman estimates. LIBOR is tied to all sorts of financial products; you may have a mortgage, student or auto loan tied to it, and your company probably borrows based on it. In other words, it drives your corporate interest expense.
Board directors need to ensure management starts thinking through the transition now. The good news is that companies still have time to get ready. The bad news? The transition will require a fundamental repricing of debt and might have a large market impact.
The largest banks are already preparing, pushed ahead by regulators on both sides of the Atlantic. UK regulators in September sent classically understated “Dear CEO” letters to the largest financial institutions in Britain, politely demanding they develop and submit by December a board-approved plan for LIBOR transition. Regional and community banks, meanwhile, are just starting their efforts.
Beyond banks, the transition affects almost all large corporations, given that trillions of dollars of debt or hedges of debt is tied to LIBOR. Yet in our conversations with treasurers, financial officers, and yes, board members of non-financial companies, we have come across few who recognize the looming issue—or are even aware of it.
Consider this an early warning.
Buried in Fine Print
Corporate loan and debt agreements generally contain language that defines what happens if LIBOR is unavailable – but is designed for a short-term contingency like a systems outage, not permanent cessation. Typical terms vary, ranging from “use the last rate,” meaning that your floating debt is now fixed, to “use prime,” meaning that your rate is now very different.
There are no criteria for what constitutes a LIBOR discontinuance, leaving companies exposed to language buried in contracts. Firms might be entitled to something better, or something worse. Does management know, or are they depending on the financial system to offer a reworked deal? That isn’t always possible; perhaps a bank will renegotiate, but bondholders might be unwilling to give back an unexpected gain.
Companies are likely to feel a financial impact not only from the changing terms of the debt itself but also from changes rippling through hedges and derivatives linked to debt. That’s because almost all these changes break the “hedge accounting” that firms use on their balance sheet, potentially increasing balance sheet volatility.
What Will Replace LIBOR?
In the end, transactions in the market won’t be defined by the regulators who are taking LIBOR off the table. Regulators indicate the transition is “market led,” so it is up to the banks and customers to define a path forward. That’s why corporations need to focus: This is a fundamental repricing of the more than 100 financial products tied to LIBOR, and the market impact is still murky.
While the regulators have not defined how economic changes will work, they have created potential replacement rates. Each of the five existing LIBOR rates will be replaced by country or region specific rates. For example, the Federal Reserve has created the Secured Overnight Financing Rate, or SOFR, and the UK Working Group recommended the Sterling Overnight Interbank Average rate, or SONIA. These are structurally very close to true “risk free” rates and therefore act differently than LIBOR. They should average lower than LIBOR as LIBOR contains features that are good for the banking system. For example, LIBOR will increase during a bank crisis like we had in 2008—and this is not in the new rates. Look for the industry to seek to replicate these features in new non-LIBOR products, which are still under development, and to seek to sell them to corporate borrowers.
All of this points to a mountain of work for corporations and their finance teams. They must inventory existing LIBOR-based obligations, determine exposures past the likely end of LIBOR in 2021, work down those exposures if possible, and get ready for a slew of new products to be evaluated.
What To Do: A Checklist for Boards
How can boards monitor this? In short, by following the script already laid out for banks by the UK regulators in September.
First, they should ensure there is leadership accountable for managing the transition. This might well be the chief financial officer or corporate treasurer, but it will vary depending on the company’s business model. And since this is a global problem, it needs to be considered and managed globally.
That leader (and team) should start by identifying exposures. These is no easy way to do this but to go through the financials and document those which are based on LIBOR, and project what will change when LIBOR goes away.
Once the exposures are understood, leaders should consider the big picture and report to the board about its implications. Companies and their bankers have a relationship that needs to survive what in the end is a technical hitch. What should be the response when a bank calls to refinance or renegotiate?
Next, board members should advise that their companies need to consider the details and build a work plan. LIBOR likely is present in more places than is obvious. For instance, systems will need to be updated. Some of these will be vendor systems, and companies need to show that they are on top of these vendors. That’s the end of the UK regulatory request—a board-approved plan. Boards should be pushing for a similar outcome unless their LIBOR exposures are negligible.
Finally, if you are a board member, you should insist your company isn’t the last to change. As LIBOR fades away it will likely get stale and products based on it could become illiquid. If your company is late to the table, it could prove costly.
For more information on how to prepare for the transition, please see Oliver Wyman’s LIBOR hub.
Paul Cantwell is a Partner in Oliver Wyman’s Finance & Risk and Public Policy Practices in the Americas. Adam Schneider is a Partner in Oliver Wyman’s Digital and Banking Practices in the Americas. Ming Min Lee is a Principal in Oliver Wyman’s Corporate and Institutional Banking practice.