13 Oct 2020

The Bank of England has written to UK banks to ask if they would be ready if interest rates were cut to zero or turned negative. Back in March, the Bank of England reduced its Base Rate to 0.1%, its lowest ever level, in order to help reduce borrowing costs as COVID-19 tightened its grip on the UK economy. In May, the Governor of the Bank of England paved the way for negative interest rates and lenders began contingency planning for this. But does that mean borrowers will soon receive interest on what they've borrowed? The answer might not be what you'd expect…

To explore this, we need to look at the applicable rate, a borrower's interest rate management and, inevitably, how both are documented. The two principal benchmark rates in the UK are the Bank of England Base Rate (used mainly for individuals and small businesses) and LIBOR, which is more typical for lending to larger businesses. While the two rates are not linked, historical trends show they tend to closely follow each other. As such, if the Base Rate becomes negative, there is a strong chance LIBOR will follow suit.

Modern loan documentation will calculate interest as the sum of the applicate rate (LIBOR or Base Rate) and the margin (or lender's pricing) for that loan. Consequently, if LIBOR turns negative, that sum is reduced. If LIBOR becomes negative by more than the margin is positive, the effect could be that a borrower is entitled to receive the benefit of that negative interest. At least one lender has offered this as an incentive in the last year. In recent years, however, the practice of including an interest rate floor in loan documents has become more common – loan agreements now commonly state that, even if LIBOR becomes negative, it will deemed to be zero. The effect of that is to ensure the lender always receives an amount of interest at least equivalent to its margin. Therefore, if a loan agreement includes a LIBOR floor, the borrower will not receive any benefit if the applicable rate becomes negative.

The story doesn’t end there. A larger borrower may also buy an interest rate swap to protect itself against fluctuations in interest rates. In return for a fixed premium, the borrower may receive the amount of fluctuating LIBOR from the hedging counterparty. Conversely, if LIBOR becomes negative, the borrower will usually be required to pay the amount of negative interest to the hedging counterparty, which is fine if the borrower also receives the same from the lender. However, if the loan agreement includes a LIBOR floor, the borrower will not receive that negative interest from the lender but may still be required to account to the hedging counterparty for the same. Negative interest rates may therefore lead to additional overall borrowing cost.

We can help borrowers understand these issues, their loan and hedging agreements and their available options.