The sub-LIBOR issue

The sub-LIBOR issue  (see further below) related to contractually specified risk components: Purchase or sales agreements sometimes contain clauses that link the contract price via a specified formula to a benchmark price of a commodity. Examples of contractually specified risk components are each of the price links and indexations in the contracts below:

  • Price of natural gas contractually linked in part to a gas oil benchmark price and in part to a fuel oil benchmark price
  • Price of electricity contractually linked in part to a coal benchmark price and in part to transmission charges that include an inflation indexation
  • Price of wires contractually linked in part to a copper benchmark price and in part to a variable tolling charge reflecting energy costs The sub-LIBOR issue
  • Price of coffee contractually linked in part to a benchmark price of Arabica coffee and in part to transportation charges that include a diesel price indexation

In each case, it is assumed that the pricing component would not require separation as an embedded derivative . When contractually specified, a risk component would usually be considered separately identifiable. Further, the risk component element of a price formula would usually be referenced to observable data, such as a published price index. Therefore, the risk component would usually also be considered reliably measurable. However, entities would still have to consider what has become termed the ‘sub-LIBOR issue’.

Some financial institutions are able to raise funding at interest rates that are below a benchmark interest rate (e.g., LIBOR minus 15 basis points (bps)). In such a scenario, the entity may wish to remove the variability in future cash flows caused by movements in LIBOR benchmark interest rates. However, IFRS 9, like IAS 39, does not allow the designation of a ‘full’ LIBOR risk component (i.e., LIBOR flat), as a component cannot be more than the total cash flows of the entire item. This is often referred to as the ‘sub-LIBOR issue’.

The reason for this restriction is that a contractual interest rate cannot normally be less than zero. Hence, for a borrowing at, say, LIBOR minus 15bps, if benchmark interest rates fall below 15bps, any further reduction in the benchmark would not cause any cash flow variability for the hedged item. The sub-LIBOR issue

Consequently, any designated component has to be less than or equal to the cash flows of the entire item. The sub-LIBOR issue

In the above scenario, where the interest rate is at LIBOR minus 15bps, the entity could instead designate, as the hedged item, the variability in cash flows of the entire liability (or a proportion of it) that is attributable to LIBOR changes.

This would result in some ineffectiveness for financial instruments that have an interest rate ‘floor’ of zero in situations in which the forward curve for a part of the r emaining hedged term is below 15bps because the hedged item will have less variability in cash flows as a result of interest rate changes than a swap without such a floor.

The sub-LIBOR issue is also applicable to non-financial items where the contract price is linked to a benchmark price minus a differential. This is best demonstrated using an example derived from the application guidance of IFRS 9. The sub-LIBOR issue

IFRS 9 Sub-Libor prohibition

IFRS 9 retains the requirement from IAS 39 that a component of the cash flows of a financial or non-financial item designated as the hedged item should be less than or equal to the total cash flows of the entire item. The new standard reiterates that all of the cash flows of the entire item may be designated as the hedged item and hedged for only one particular risk. For example, in the case of a financial liability that has an effective interest rate below LIBOR, an entity cannot designate both:

  • a component of the liability equal to interest at LIBOR (plus the principal amount in the case of a fair value hedge); and
  • a negative residual component. [IFRS 9 B6.3.21–B6.3.22]

However, for example, in the case of a fixed rate financial liability whose effective interest rate is below the benchmark rate (e.g. 100 basis points below LIBOR), an entity may designate as the hedged item the change in the value of the entire liability (i.e. principal plus interest at LIBOR minus 100 basis points).

In addition, if a fixed rate financial instrument is hedged some time after its origination, and interest rates have changed in the meantime, then an entity can designate a risk component equal to a benchmark rate that is higher than the contractual rate paid on the item. The entity can do so provided that the benchmark rate is less than the effective interest rate calculated on the assumption that the entity had purchased the instrument on the day it first designated the hedged item. [IFRS 9 B6.3.23]

EXAMPLE – Sub-LIBOR issue in a non-financial context

An entity has forecast sales of a specific type of crude oil from a particular oil field that is valued using Brent crude oil. Suppose that it sells that crude oil under a contract using a contractual pricing formula that sets the price per barrel at Brent minus 10 with a floor of 15. In this case, the entity can designate as the hedged item the entire cash flow variability under the sales contract that is attributable to the change in the benchmark crude oil price.

However, the entity cannot designate a component that is equal to the full change in Brent. Therefore, as long as the forward price (for each delivery) does not fall below 25, the hedged item has the same cash flow variability as a crude oil sale at Brent (or with a positive spread). However, if the forward price for any delivery falls below 25, then the hedged item has a lower cash flow variability than a crude oil sale at Brent (or with a positive spread). [IFRS 9 B6.3.25]

The Technicalities

The swap market allows borrowers (especially those at a disadvantage to borrower from banks) to lock in the best rates on their debt financing. Customarily, banks and other financial institutions lend money (specifically floating-rate loans) at a spread over LIBOR. In reality, lenders do their best to ensure the spread is a high as possible, while borrowers attempt to have it as low as possible.

The spread size depends on a mix of subjective and objective factors including a borrower’s financial solvency and credit history, a lender’s liquidity and willingness to lend, the supply and demand of funds in the broader financial market (which in turn affects the level of interest rates), among others. Disadvantaged borrowers, those who are denied access to bank loans or unable to borrow at low rates, can enter the swap market to improve the borrowing terms in a synthetic fashion.

For example, a firm wants financing and is offered LIBOR+100 on a floating-rate loan. However, it feels that it should have been able to borrow at a lower rate given its high creditworthiness. Suppose the firm issued a 5-year bond at a fixed rate of 7.10% (actually it locked in this rate for the life of the bond). Unfortunately for the firm, rates dropped after one year. Therefore, it entered the swap market and received 7.25% against LIBOR. In this way, the firm can pay, for the remaining life of the bond, LIBOR- 15:

Table – Effective rate = LIBOR – spread = LIBOR – 15 The sub-LIBOR issue

The sub-LIBOR issue Interest on bonds (7.10%) The sub-LIBOR issue The sub-LIBOR issue
The sub-LIBOR issue SWAP fixed rate 7.25% The sub-LIBOR issue The sub-LIBOR issue
The sub-LIBOR issue SWAP floating rate (LIBOR) The sub-LIBOR issue The sub-LIBOR issue
The sub-LIBOR issue Effective rate (LIBOR – 15) The sub-LIBOR issue The sub-LIBOR issue

The synthetically created rate is illustrated below:

Overall, the firm, by using the swap market wisely, could save 110 basis points (100 on the best floating-rate offer and 10 from the synthetic sub-LIBOR rate).

Background from IASB meeting 12-15 April 2011 – Sub-LIBOR issue

The hedge accounting exposure draft carried forward the existing hedge accounting guidance from IAS 39 related to designation of portions of items that are larger than the cash flows of the hedged item (commonly referred to as the ‘sub-LIBOR issue’).

While the issue is not limited only to hedging of interest rate risk, this is where the issue primarily arises; specifically because certain instruments are priced sub-LIBOR and therefore have cash flows less than the benchmark interest rate. The sub-LIBOR issue The sub-LIBOR issue

The sub-LIBOR issue

During the comment letter process and Board’s outreach activities, the staff recognised there was some level of confusion around the guidance included in the exposure draft. Some respondents requested that the Board differentiate between sub-LIBOR instruments with a floor at zero per cent and instruments without a floor as the original agenda paper prepared by the staff noted the issue only arises when the interest-bearing instrument has a floor.

Additionally, respondents requested the Board reconsider the restriction with respect to 1) hedging a net exposure where the aim is to lock in a fixed interest margin, 2) hedging a non-financial item priced below the benchmark, and 3) hedging of core deposits and macro hedge accounting. The sub-LIBOR issue The sub-LIBOR issue

For the discussions today, the staff asked the Board to focus solely on the issue of using a hedging instrument based on a benchmark risk to hedge an item with total cash flows less than those associated with that benchmark, and the purpose is to hedge a fixed margin between an interest-bearing financial asset and an interest-bearing financial liability.

The staff proposed retaining the restriction from the exposure draft for portions of items larger than the cash flows of the hedged item when an interest rate floor is in place. Their belief that doing so avoids counter-intuitive results such as paying interest on an asset and deferral of hedge ineffectiveness while illustrating that a fixed’ margin does in fact become variable when LIBOR drops below a critical range (i.e., the range of the negative spread to LIBOR). The sub-LIBOR issue

The discussion began with one Board member asking a question that since the guidance from IAS 39 was carried in to the exposure draft, whether it was possible to get hedge accounting today for these issues. The staff responded that hedge accounting was possible, but because of the 80-125% effectiveness threshold, entities may have experienced issues with failing hedge accounting, particularly in today’s current low interest rate environment.

One Board member suggested that taking a second look at the wording in the exposure draft may help to resolve a lot of the questions around the issue. The Board tentatively decided to retain the restriction in the exposure draft when an interest rate floor is in place but to consider ways to further clarify the guidance.

Read more on FAQ | IFRS:

Hedge Risk components General requirements
Contractually specified risk components
Non-contractually specified risk components
Inflation as a risk component

 

The sub-LIBOR issue

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