Over the summer the reliability of LIBOR has been brought into question and led to the Financial Services Authority launching an investigation into the benchmark rate: the Wheatley Review. One of the big questions that needs to be answered is how LIBOR should be set when there simply isn’t an interbank lending market. To put this in perspective, the FSA estimates that only eight of the 150 LIBOR periods notified by the British Bankers Association are based on reasonable trading volumes.
One rarely discussed solution would be to stimulate the interbank lending market. The Bank of England could easily achieve this by making it more punitive for banks to withhold capital from the market. As of 30th September, the Bank held £262.3bn in its reserve account on behalf of UK banks, largely as a result of the Bank’s asset repurchase programme, or quantitative easing.
If, however, the Bank were to charge banks for the benefit of its unquestionable AAA security, it would be easy to envisage a sizeable increase in interbank lending at potentially negative rates. This may sound extreme, but there is a precedent. This July, Denmark’s central bank cut its official deposit rate to -0.2% in an attempt to arrest the inflow of deposits into the currency, betting on a revaluation of the Kroner. Since this date the Kroner’s overnight LIBOR rate has been consistently negative.
It is clear that banks do not underestimate this risk. Since August, the Loan Market Association’s standard documentation for secured real estate loans has included a LIBOR floor – clauses that protect banks from having to make payments to borrowers if LIBOR turns negative.
The risk to borrowers, however, is that the floor in the loan is not matched within the terms of the associated hedging. For example, if a borrower has a 2% swap rate and LIBOR is -0.5%, the total amount paid under the swap would rise to 2.5%; the negative LIBOR receipt becomes a payment due to the bank At the same time, if the margin is 3% under conventional terms the net payment on the loan would fall to 2.5%, keeping the total cost of debt constant at 5%. But if a 0% LIBOR floor is embedded in the loan, the overall cost of debt will increase to 5.5%.
The LIBOR floor also poses additional potential risks to borrowers, which are not being recognised. As currently drafted, the LIBOR floor would destabilise the hedging relationship if LIBOR rates did become negative. As a result, the effectiveness of hedges would be impaired and companies could be forced to abandon hedge accounting.
Moreover, EU rules governing over-the-counter derivatives, such as swaps, state that an interest rate hedge must measurably reduce risks from changes resulting from fluctuations of interest rates, if it is to avoid the central clearing requirement. Clearly a conventional swap hedging a loan with an embedded floor would not perform this task if LIBOR rates became negative. This could have devastating effects for borrowers looking to refinance existing loans, since the central clearing requirement might force them to fully collateralise the mark-to-market valuation of their swaps with a central counterparty.
Worse still, if one such swap caused the borrower to breach the central clearing thresholds set by the regulation, the borrower would have to transfer all its other swaps into central clearing. For companies with long-dated swaps implemented in a bygone era, this is likely to be terminal.
It is apparent that the Loan Market Association has not fully considered the potential ramifications that including the LIBOR floor entails for borrowers. Of course, none of this need be a concern if, as expected, LIBOR remains positive. However, given that the banks have decided to protect themselves from negative interest rates, it seems only prescient to point out the potential negative implications of this action for borrowers in advance, rather than in the ‘pay later’ situation that banks’ customers normally suffer.
Bill Bartram is a director at JC Rathbone Associates