By Cathryn Barber & Gerard Souness*
New Zealand isn’t there yet and may never get there, but the Reserve Bank Governor has slashed the Official Cash Rate (OCR) and is musing publicly about negative interest rates.
We look at what it might mean for corporate borrowers, based on the experience in Europe and Japan.
These are general observations. The effect on you will depend on the structure of your particular funding arrangements.
Zero floor – most facility agreements contain a zero floor which provides that, if the base rate is negative, it is deemed to be zero for the purposes of calculating interest under the agreement. That means the borrower is always required to pay at least the margin and there is no deduction to reflect a negative underlying market base rate.
Lender interest payments – can a borrower benefit from a negative base rate? Probably not. No standard facility agreement requires a lender to make a reverse interest payment to a borrower for amounts it has lent and we consider it unlikely that a New Zealand Court would view the contractual relationship as creating this obligation.
Hedging – despite the International Swaps and Derivatives Association providing documentary options for both zero floor and negative interest rate methods, calculation of the floating rate payment to be received by a borrower under a swap transaction will not typically incorporate a zero floor provision to match their facility agreement. Banks justify this on the basis that any change to the floating rate calculation method would incur operational costs and a market premium reflecting the difficulty in back-to-back hedging – costs which would be passed onto the borrower and would generally negate the purpose for requesting such protections.
Accordingly, the borrower – having entered into the hedge to mitigate risk – may be faced with a potentially expensive mismatch between the floating rate payment it is to receive under the swap (reduced in a negative base rate scenario) and the (zero floor) interest payment it is obliged to pay under its facility agreement. If the borrower is required to make a payment under the swap due to a negative rate, the borrower may even be put in a position where it is obliged to make that payment together with the facility margin.
Three solutions which have been deployed against negative interest rates overseas are: simple interest rate cap swaps, a shift to fixed rate loans, or applying the zero floor protections in the facility agreement only to loans that are not counter hedged with the lender.
Market disruption – as interest rates drop, there is an increased likelihood that lenders will seek to invoke the market disruption provision in a facility agreement. This can entitle the lender to increase a facility’s base rate if its cost of funding the loan (or a certain proportion of the loans) exceeds the market base rate due to market circumstances not limited to that lender.
Lenders have traditionally shied away from triggering these provisions to preserve market reputation, but negative interest rates may change the elements of that equation. It should be noted that not all market disruption provisions are created equal and a low or negative base rate will often not qualify, in and of itself, as a market disruption event.
Increased costs – low or negative base rates will also encourage lenders to pass on any additional regulatory costs they have historically absorbed (such as central bank levies).
Most borrowers will have limited ability to deviate from these standard financing provisions. To the extent they can achieve matching hedging, this is likely to come at a cost. While facility agreement and hedging terms are varied, the positions outlined above are well entrenched market standards and, particularly in the current environment, we consider it unlikely that the banks would agree to their deletion or any substantial dilution.
*Cathryn Barber and Gerard Souness are partners at law firm Chapman Tripp. This article was first published here and is used with permission.