On March 15, 2011, UBS AG announced in its 2010 annual report1 that it was being investigated by the U.S. Securities and Exchange Commission, the U.S. Commodity Futures Trading Commission and the U.S. Department of Justice for possible manipulations of the London Interbank Offered Rate (LIBOR). LIBOR rates are calculated daily by the British Bankers Association (BBA) on the basis of rates that panel banks indicate they would have to pay in order to borrow funds on the interbank market. The BBA drops the highest and lowest quartiles of the rates provided by the panel banks and calculates LIBOR based on the remaining 50 percent of submitted responses. UBS AG, as a panel bank, is suspected of claiming that the rates it was being charged for interbank borrowing were lower than the rates actually paid, thereby artificially lowering the calculations of LIBOR. At the time of this article, panel banks Barclays Plc, Citigroup Inc. and Bank of America Corp. have also confirmed that they are subject to the investigation, while WestLB AG and Lloyds Banking Group Plc are alleged to have been sent similar subpoenas.
The methodology for calculating LIBOR was called into question at the beginning of the credit crisis, when it was strongly suggested that the rates panel banks were submitting to the BBA were lower than the rates those banks paid on the open market. Concerns were raised again last year when European banks on the panel with heavy exposures to Greek sovereign debt submitted rates at levels similar to those from other panel banks with less exposure to Greece. In response to these criticisms, the BBA expanded the number of panel banks, but otherwise maintained its system for determining LIBOR.
U.S. lenders typically protect themselves from uncertainty surrounding LIBOR through the use of LIBOR floors and/or market disruption provisions built into their credit agreements. As their name would imply, LIBOR floors set an artificial level below which LIBOR cannot drop, generally between 1 percent and 3 percent. Market disruption provisions allow the administrative agent to use an alternative rate (such as the fed funds rate, prime rate or a reference bank rate) if LIBOR cannot be determined or if a certain percentage of the lenders notify the agent that LIBOR does not reflect their cost of funds.
As lenders compete with each other to offer more advantageous financing terms to the strongest credits, they will sometimes forgo a LIBOR floor while at the same time reducing their margins. Without the protection of LIBOR floors, lenders must either exercise the market disruption provisions (if available to them) or make up the difference in funding costs by eating into their margin. Even when lenders are able to invoke the market disruption provision, they are almost invariably unwilling to do so since it would be an open admission that they are unable to finance their interbank borrowings at market levels. In these situations, lenders may find themselves making significantly lower returns on their loans than originally anticipated, and in transactions with very low margins, even incurring net losses.
Pepper Point: The announced investigations into possible manipulations of LIBOR provide lenders additional justification not only for requiring LIBOR floors from borrowers, but potentially for setting such floors at higher levels.
Pepper Point: Arrangers should carefully consider whether the absence of LIBOR floors could deter potential syndicate members from participating in loans. This is especially true in cases in which syndicate members are expected to include smaller banks and non-traditional lenders, whose cost of funds might be higher than LIBOR even if it accurately evidences the funding costs of panel banks.
Pepper Point: Given the renewed uncertainty regarding LIBOR rates, lenders may wish to review whether LIBOR truly reflects their own cost of funds and consider offering alternative rates to their borrowers.