Negative interest rates have become a very real possibility in the United States. Indeed, negative interest rate policy has already been implemented in other countries. Aside from the obvious issue of reversing certain aspects of the economics of a credit agreement between a lender and borrower, negative interest rates pose other potential tax, regulatory, and transactional issues. This advisory explores some of these issues and potential solutions.
On February 11, 2016, in testimony before the Financial Services Committee of the US House of Representatives, Federal Reserve Board Chair Janet Yellen stated that the Federal Reserve is “taking a look at” negative interest rates and that she “wouldn’t take those off the table.” Although the United States approached negative interest rates in late 2008, the target federal funds rate (the target rate set by the Federal Open Market Committee to implement monetary policy) remained at 0% to 0.25% until it was raised to its current level of 0.25% to 0.5% at the end of 2015. Nevertheless, the Federal Reserve now appears to be preparing the banking industry for the prospect of negative interest rates through its supervisory function. For instance, the Federal Reserve recently instructed banks subject to stress testing requirements that, for the 2016 cycle, they must employ a “severely adverse scenario” that features a severe global recession in which the US unemployment rate rises five percentage points to 10%, accompanied by a heightened period of corporate financial stress and negative yields for short-term US Treasury securities.
In Europe and Asia, negative interest rates are a well-known recent phenomenon in the financial markets. The European Central Bank has maintained a negative interest rate policy for some time, and this month announced a further reduction into negative territory for its deposit rate. Certain European countries, such as Switzerland, Sweden, and Denmark, also maintain negative interest rates, and in April of last year Switzerland sold bonds with a negative yield. The Bank of Japan announced that it will implement a similar policy and recently sold new 10-year bonds with a yield below zero. Negative interest rate policies effectively penalize banks for depositing their excess funds with their central banks and are designed to encourage banks to lend their capital out into the economy. Some commercial banks have managed negative interest rates and the attendant penalty on saving capital by absorbing the additional costs. Others have begun charging clients for maintaining deposits.
Considerations for Managing Negative Interest Rates
The ultimate policy goal underlying a negative interest rate policy for a central bank is to promote economic growth and manage inflation. However, this policy may negatively impact various features of credit instruments and their agreements in ways that lenders, borrowers, and other loan and swap market participants must understand. Certain of these are discussed below.
Floating Rates and Loan Repricing. Most directly, negative interest rates affect the re-pricing of floating rate loans, which are often computed as a rate some number of basis points above, or below, a base rate. The Swiss franc LIBOR, a base rate often used for Swiss franc-denominated loans, has been negative for well over a year as a result of policy decisions taken by the Swiss National Bank at the end of 2014. Euro LIBOR, another commonly used base rate, has also regularly been negative since 2015, especially for shorter maturities, and Euribor rates (a reference rate for euro-denominated forward rate agreements, short-term interest rate futures contracts, and interest-rate swaps) have also been negative.
Operational Concerns. Negative interest rates raise a host of operational issues. Banks have reported that their accounting and operating systems often do not contemplate negative interest rates. Negative interest rates do not, for instance, permit for straightforward responses in bank accounting systems to queries as to the rate on a loan such as what the “interest” on a loan is or how negative rate payments should be made, if at all.
Contract Interpretation. When loan documents do not provide a rate “floor” on the base rate (e.g., the LIBOR component of a floating rate loan) it is likely that a court analyzing a loan agreement under New York law would conclude that the interest rate calculation should be made as provided in the agreement, even if the base rate becomes negative. The result would likely mean that the calculated interest rate could be less than the margin, or even less than zero.
One drafting solution to the negative interest rate problem is to include a base rate floor in the loan documentation. This drafting option is contemplated in model documentation of the London-based Loan Market Association. Language can be added to the base rate definition to clarify that the base rate would never fall below zero (such as, “provided, however, that in the event LIBOR is less than zero, LIBOR shall be deemed to be zero.”). Borrowers located in countries with exchange and similar controls would need to ensure that, in any required transaction registration with the central bank or similar authorities, appropriate notation is made and regulators consulted, as local systems may not contemplate interest rate floors or the possibility of negative interest rates.
Regulatory Treatment. In drafting solutions to the negative interest rate problem, parties should be alert to the potential for unintended regulatory consequences. For example, although many types of loans and commercial agreements are not considered “swaps,” parties may inadvertently introduce swap treatment into their documents via inappropriate incorporation of certain forms of interest rate locks, caps, or floors. In the United States, following the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act and implementing regulations issued by the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC), agreements and transactions are considered swaps or security-based swaps depending, among other things, on their payment terms and whether payments are linked to the values of rates, securities, indexes, or commodities. The risk of not properly characterizing or defining a floor rate can be significant, because swaps are subject to numerous reporting, recordkeeping, business conduct, and other requirements. Further, after certain transaction thresholds are reached, a firm may become subject to CFTC or SEC registration, capital, and governance standards. Parties may be able to avoid swap or security-based swap treatment by careful drafting when creating a rate floor structure.
Tax Issues. Tax issues may arise in connection with negative interest rates. For example, parties may need to consider whether their structuring and/or drafting solution ‒ such as a floor rate ‒ creates a tax event. If no changes are made to documents, then parties may need to consider whether negative interest would be deemed “income” to the borrower and an expense of the lender. A further question that might arise is whether a lender would be required to “gross up” any interest rebates or principal reductions to account for potential borrower tax events, a circumstance generally not provided for in standard loan documentation.
Hedging Issues. Negative interest rates also raise concerns with respect to interest rate swaps that are used to hedge a borrower’s interest rate exposure on a floating rate loan that is subject to the “deemed to be zero” clause referred to above. Borrowers should be mindful of a potential mismatch between the floating rate specified in their loan and the floating rate provided for in their related swap.
In this regard, we note that interest rate swaps typically incorporate either the 2000 ISDA Definitions or the 2006 ISDA Definitions, both of which provide for the “Negative Interest Rate Method” and the “Zero Interest Method” to address negative interest rates. The Negative Interest Rate Method applies to an interest rate swap, unless the parties specify otherwise. Under the Negative Interest Rate Method, if the floating rate leg under the swap is negative, the borrower, instead of paying only the fixed leg of the swap, would also be obligated to pay the absolute value of the (negative) floating leg, while not receiving a corresponding payment from the lender under the loan. To avoid this mismatch, the parties may elect to apply the Zero Interest Rate Method, which provides that if the floating leg is negative, the floating rate payer is deemed to owe zero and the borrower is obligated to pay the fixed leg only. However, borrowers should be aware that electing to include this method will likely increase the price of the swap.
Legacy Arrangements. Legacy agreements with interest rate provisions that predate a jurisdiction’s negative interest rate policy may also pose a concern. If such agreements do not already contain an interest rate floor, a lender bank may wish to amend its agreements to clarify their intended economic treatment. However, in cases where a borrower will not agree to modify its agreement with the addition of a floor, lenders may wish to pursue other contractual remedies in the face of ambiguity or payment obligations triggered by negative interest rates.
Negative interest rate policies pose a number of operational and legal challenges for lending banks and counterparty borrowers. As central banks, including the United States’ Federal Reserve, seriously consider implementing or extending such policies, parties may wish to implement forward-looking solutions to their agreements and review gaps in existing legacy agreements. Whether drafting solutions are implemented or not, parties would be wise to consider how negative interest rates impact their transaction economics and tax treatment to manage and/or hedge their exposure.