Negative LIBOR

Banks Mull Treatment of Potential Negative LIBOR in Credit Agreements

In today's low interest rate environment, banks and others that follow the leveraged lending and other credit markets are increasingly interested in the effects that negative rates could have on their existing loan facilities that bear interest based on floating rates.

On February 10, 2016, in testimony to Congress's House Financial Services Committee, Federal Reserve Chair Janet Yellen did not say whether the Fed will increase its benchmark interest rate again in March after lifting it in December for the first time in nine years,1 but in response to a question regarding whether the Fed has legal authority to implement negative rates, Yellen stated that she was "not aware of anything that would prevent [the Fed] from doing it." 2 The European Central Bank has also been widely expected to push deposit rates further into negative territory, and3 central banks in Japan and Switzerland among others have adopted a negative rate for commercial bank funds held on deposit at the central bank. 4 Instead of being paid by the central bank, the commercial bank now pays the central bank when it deposits money. 5 By charging the banks money to hold deposits, central bankers aim to make it more attractive for banks to deploy their reserves into the credit markets—which ideally will have a corresponding positive effect on the larger economy.

Economists, central bankers and others have begun to speculate that the various London Interbank Offered Rates, or LIBOR, the benchmark rates at which the largest banks lend to each other in the interbank market in various currencies and for various durations, may soon land in negative territory. Euribor, a similar rate for euro-denominated loans, is already in negative territory, as is LIBOR for Swiss Franc denominated loans.

LIBOR is important to those in the U.S. leveraged lending market because a majority of credit agreements governing commercial loans have interest payable, at the borrower's option, either at LIBOR plus a spread or margin or the "Base Rate" (typically the highest of one-month LIBOR plus 1.00%, the federal funds effective rate plus 0.50% or a major bank's "prime rate") plus a spread (which is usually 100 basis points lower than the LIBOR margin).

Recently, some lenders have recognized the possibility of LIBOR being negative and, as a result, such lenders require that credit agreements have a "zero floor," meaning that if LIBOR is less than zero, the rate shall be deemed to be zero for the purposes of the agreement. This follows a similar established practice in Europe. These new protections help the lender by eliminating the lender's risk of the interest rate being less than the spread or margin or, in the extreme, of actually paying the borrower interest for loans made by the lender to the borrower. Despite the implementation of this fix in new agreements, however, questions remain regarding credit agreements signed before the "zero floor" convention was adopted or that otherwise lack a zero floor, and how LIBOR will be treated...