The consequences of not being able to use negative reference rates (e.g. WIBOR, EURIBOR) in loans can be very severe for companies. A frequent practice of banks can expose enterprises to losses running into millions of zlotys. Check your credit facilities for harmful mechanisms.
In recent years, due to the negative EURIBOR rates, banks have established a standard, which is very unfavourable to clients, of offering only such loans in EUR where the interest rate cannot dip below zero. This is a massive problem. Today, it affects not only “euro” borrowers, but also, more recently, “zloty” borrowers, who – as in the case of loans in EUR – are now being offered financing only if they accept the provision that they cannot benefit from possible negative WIBOR.
Banks do this despite having access to negative funding rates in the interbank market and without a corresponding reduction in the size of their lending margins. In this way, they systematically and automatically increase their loan profitability by the value of the negative EURIBOR, at the same time increasing the cost of finance for their customers by the same value.
It is worth paying a little more attention to this issue. Consider the implications of this practice for entrepreneurs and for banks beyond the general conclusion stated above.
“I had no idea I was selling something with this loan… !”
This is exactly the reaction we get from our clients at Grant Thornton every time we come on board to assist them in the process of mandatory hedging of the interest rate risk arising from these loans. It comes as a huge surprise when the bank discloses at this stage that the non-negative EURIBOR provision in the loan is a derivative. Or more precisely – a ZERO FLOOR option built into the loan. Clients at this point realize that:
- this option has a definite market value,
- they unwittingly sold it by signing a loan agreement,
- they didn’t get paid for it (e.g. in the form of an option premium),
- its existence and value were concealed by the bank at the stage of offering the loan (not to mention the MIFID procedure, which banks are obliged to apply in respect of financial instruments),
- they must, in addition, repurchase it for live cash at the time the mandatory interest rate risk hedge is executed (e.g. the most common hedging transaction, the Interest Rate Swap, IRS).
It is this last point that is the final straw. When entering into an IRS hedging transaction, the bank is forced to disclose the embedded FLOOR option in the loan. This is because of the need to “match” the definition of reference rates on the hedged item (i.e. the loan) and the hedging item (i.e. the IRS). As in the IRS transaction settlements are based on market EURIBOR rates (and thus also negative ones), the hedging will only be effective when the non-negative EURIBOR provision is removed from the loan. However, in order to retain the benefit of this provision after its removal from the facility agreement, the bank must disclose that it is the same as the FLOOR option, because only then can it be “sold” to the customer. Technically, it is a classic sale transaction of this option with a price (option premium) equal to zero where the actual market value is included in the margin on the IRS transaction, the price of which then becomes very unfavourable to the client.
The paradox is that the customer, by entering into an IRS transaction at an inflated price, de facto repurchases for live cash something that they had previously unknowingly given to the bank for free when taking out a credit facility.
What is the market value of the ZERO FLOOR option?
We are talking about considerable sums here. Let us consider, for example, a 5-year loan of EUR 50,000,000 based on EURIBOR 3M (for the sake of simplicity without amortization) fully hedged by an IRS transaction. The interbank price on this deal at the time of writing this article is -0.35% p.a. The corresponding FLOOR option with ZERO exercise price reflecting the non-negative reference rate provision in this loan will cost as much as EUR 1,250,000 (!). In terms of the number of basis points in an IRS transaction, this increases its price by as much as 50 b.p. (!), i.e. from -0.35% p.a. to +0.15% p.a.
The amount of EUR 1,250,000 is therefore nothing more than an increase in the cost of finance as a result of agreeing to the non-negative EURIBOR provision in the loan.
Is this legal?
To put it mildly, the procedure described here seems very unfair. But is it illegal? For now, it’s a bit of a grey area. Even if something clearly feels like “daylight robbery”, it doesn’t have to be illegal. There are independent courts to determine this, and they may have to address the issue. Are we headed for another financial market scandal? Also hard to say. It depends first and foremost on the level of disadvantage felt by bank customers. They seem to have logical-sounding misgivings, though not necessarily justified under the law. Essentially, customers feel hard done by when they realize that:
- they practically gave a financial instrument to a bank in a loan, only to have to buy it back later for a huge amount of money,
- the bank, at the time the loan was offered, didn’t offer them a choice between a loan with and without the provision for non-negative reference rates,
- if the bank itself admits to buying a derivative in the form of a ZERO FLOOR option within the facility agreement, then why did it not comply with the standards applicable to financial instruments trading (MIFID procedure) with the customers?
How do banks respond to customer concerns?
In our experience, the banks’ main argument is that a loan is a loan and not a financial instrument, so it is automatically exempt from the MIFID regulations. As to the non-presentation of an alternative financing offer, i.e. one that would allow for market reference rates, the banks argue that this would go beyond the accepted market standards and is therefore not on the table. Besides, they assume in advance that such a proposal would be less attractive to the customer due to the higher loan margin compared to the standard offer. And when asked why they have a provision for non-negative reference rates at all, despite having access to market (including negative) rates, they reply that they have to compensate somehow for leaving customer deposit rates at or above zero…
Are these arguments convincing?
It is rather hard to agree with banks. After all, it is the banks themselves who report that the financial instrument is embedded in the loan facility. When concluding the aforementioned IRS transaction with a customer, they additionally make a repurchase transaction of the FLOOR option, the sale of which the customer had no idea about at the time of signing the facility agreement. Customers have purchase confirmations for these options from banks. It can therefore hardly be regarded as anything else than a financial instrument. The question regarding the application of MIFID procedures seems quite legitimate.
The argument concerning the possible disadvantageous differences in the size of the loan margins depending on whether or not a non-negative reference rate is used also seems questionable. This is evidenced by the fact that recently offered loans both in EUR (with this provision) and in PLN (without this provision) had identical loan margins. In addition, they had not decreased since the application of the new standard.
Finally, there is the argument that banks “compensate” for their losses on non-negative deposits by benefiting from the provision for non-negative reference rates in loans. This raises an important question – why should borrowers sponsor depositors? Why should one category of bank customers benefit from the losses of another?
It is unclear how this situation will develop in the near future. However, it is certain that as the awareness among borrowers increases, so does their belief that they are being disadvantaged by banks. Disadvantaged by not being informed about the additional costs of funding.
