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Rate Floors in Commercial Loan Agreements

Over the past few years, rate floors have become standard in commercial loan agreements. Following the 2008 financial crisis, lending rates dropped significantly and a sustained period of low interest rates has followed. There have even been instances of interest rates for certain currencies becoming negative. To protect against negative interest rates, the lending market has adopted rate floors, particularly with respect to LIBOR rates. The purpose of rate floors is to give lenders a guaranteed return on their loans even in the event that rates become negative. In Canada, this development has resulted in floors on LIBOR and CDOR (Canadian Dollar Offered Rate) rates.

What drives negative interest rates? It is well known that cash hoarding can occur in connection with preparations for an insolvency filing. Cash hoarding can also occur with solvent businesses and individuals during periods of economic uncertainty and deflationary times. Rather than investing funds in the market place, businesses will hang onto liquidity in order to minimize perceived future risk. This lack of spending decreases demand and increases supply, both of products and labour force, and has a ripple effect through the economy. Central banks, in response, typically reduce interest rates in an effort to stimulate spending.

Private financial institutions also stimulate reduced interest rates. Banks determine how much credit will be extended, which in turn affects the quantum of excess funds that are deposited with the banks. Supply of credit is tied to the economic and credit cycle. When access to credit becomes more challenging, savings increase and central banks step in to stimulate spending through lower interest rates. A low interest rate environment suggests that central banks in general are thin on their ability to maneuver any further, their capacity to stimulate spending diminishing.

As reported in the 86th Annual Report from the Bank for International Settlements, productivity levels are unusually low and global debt levels are at a historical high, leaving the global economy exposed (Bank for International Settlements, 86th Annual Report: 1 April 2015 – 31 March 2016 (Basel, Bank for International Settlements, June 26, 2016) (the “BIS Report”)). Despite best efforts on the part of central banks to avoid the crisis, there has been a global inability to weather the storm of global economic cycles, indicating that there has been too much reliance placed on debt for growth. Notwithstanding amendments currently in place to bind interest rate floors to zero, we have seen the implementation of negative interest rates by Danmarks Nationalbank, the European Central Bank, Sveriges Riksbank, the Swiss National Bank and, more recently, the Bank of Japan (BIS Report, supra).

Negative interest rates are a form of quantitative easing employed by central banks to bolster the economy. Simply, a negative interest rate has the effect of charging interest to banks on deposited funds. It imposes a penalty on depositors and rewards spending. The intent is to encourage spending and investing rather than saving. Negative interest rates, in theory, affect financial institutions themselves and not consumers directly. A central bank’s overnight lending rate, as determined daily, calculates the cost of inter-bank lending with the central bank acting as a warehousing facility for any excess reserves that the banking system could not internally reconcile. These rates, therefore, impact only those funds exceeding certain amounts that the central bank is holding on behalf of financial institutions. The implied goal of negative interest rates is that financial institutions would rather lend or invest those excess monies, rather than pay an interest penalty for keeping deposits with the central bank.

To the extent negative interest rates are intended to stimulate lending, improve access to credit, decrease savings and increase spending, rate floors in credit agreements can be seen as the attempt of private financial institutions to thwart central bank policy. Lenders and business borrowers have always been able to set interest rates, of course, but typically this takes the form of margins added to prime rates. Rate floors are an attempt to regulate what the prime rates themselves can be. In that sense, rate floors are novel. Rather than business borrowers being charged interest rates which move freely up and down as prime rates move, the downward movement of these rates is limited.

Typically, rate floors are built into the definitions of the rates in a credit agreement. For instance, LIBOR may be defined as follows:

LIBOR means, for each interest period, the interest rate expressed as a percentage rate per annum calculated on the basis of a 360 day year, equal to the rate for deposits in U.S. dollars in the London, England inter-bank market, for a period comparable to such interest period, which appears on the “LIBOR01 Page” of the Reuters Money Rates Service (or any successor source from time to time for such rate) as of 11:00 a.m. (London, England time) on the second business day preceding the first day of such interest period.

The rate floor language added to the end of the definition typically says “but if this rate is negative, LIBOR shall be zero for purposes of this credit agreement”.

As an aside, although this approach has become widely accepted in the market, arguably it should be possible for borrower’s counsel to negotiate a change to the rate floor language such that the rate for purposes of the credit agreement is deemed to be zero only if the rate in question plus the applicable margin becomes negative. The result being that if the negative rate plus the applicable margin remains above zero, the negative rate shall continue to be used in calculating the interest rate payable.

What is striking here is that a fundamental shift in the way interest rates are calculated – a direct contractual manipulation of the applicable central bank prime rate – seems to have been little challenged and, in fact, little discussed in the market. Perhaps this is an indication of how poorly negative interest rates are understood or more simply an intuitive reaction to an essentially counter-intuitive policy measure.

[Based on a paper written by Peter Birkness and Sarah Hawco, “Cause and Effect: Oil Prices and Calgary Lending Practices: An Examination of Recent Developments in the Calgary Lending Market”, Annual Review of Insolvency Law (2016), Janis P Sarra and Justice Barbara Romaine, eds, (Toronto, ON: Thompson Reuters Canada Limited, 2017)]

banking Rate Floors

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