Since 2015, negative interest rates have become a real issue for our financial markets, and therefore for our financial institutions, corporations, and consumers. Oliver Stevens summarizes the legal consequences of this interesting evolution.
Negative interest rates: banks and banking products under pressure
This evolution, which was inconceivable until a few years ago, not only puts pressure on the profitability of banks and insurance firms, but also affects a fair number of classic banking products and financial instruments directly:
- A number of banks apply a negative interest rate to deposits belonging to (major) corporations, which means that these corporations must pay the bank to keep their money as deposit.
- Borrowers having entered into credit agreements with a variable interest rate try to have their banks apply this negative interest rate consistently so that the borrowers are compensated up to the negative interest. Borrowers indeed wish to be paid by the banks instead of the other way around, i.e., that they pay the banks interest. For a limited number of old mortgage loans with a variable interest rate and an interest refund mechanism (ristorno), such negative interest has reportedly been paid out to the relevant borrowers already.
- Belgian banks are currently investigating whether they can or will offer retail customers a zero interest rate for their savings accounts (through so-called non-regulated savings accounts).
- Parties to hedging transactions using interest rate derivatives are faced increasingly with the adverse effects of the current negative interest rate environment, which were not foreseeable at the time they set up their hedging strategy.
- Some large multinationals have recently started to issue corporate bonds with a negative interest rate (often using zero-coupon bonds with an above-par redemption value).
A two-fold challenge
These phenomena provoke some fierce reactions from both the public and the political world. The macro-economic consequences as well as the adverse impact on the average investor and depositor are especially being emphasized. Financial institutions, insurers, investors, and their legal counsel need to substantially adapt their way of thinking and operating in a negative interest rate environment. Less attention is given to the fact that this drastic change in the financial markets also triggers questions about our legal approach to certain classic financial products. From a legal perspective, it might be necessary to call into doubt some of the traditional legal concepts and approaches.
Legal counsel are faced with a two-fold challenge: firstly, must the legal approach to common banking transactions and products not be changed in the future so that the right balance can be struck between the respective interests of the relevant parties? And secondly, how should numerous ongoing transactions and products today be managed - while taking into account the agreed upon contractual framework with the client - or, where possible, how should these transactions and products be adjusted to avoid that the adverse impact of the modified interest rate environment would be too substantial? Moreover, this two-fold exercise will often have to take place in situations where multiple contracts and products are involved (e.g., a credit agreement with a variable interest rate and a swap or deposit with a negative interest rate).
The legal challenges with regard to the negative interest rates are probably best illustrated in relation to banking deposit.
For the future, this will evolve (in certain scenarios) from an instrument that generates money for the client (savings and current accounts) into an instrument that “costs” money.
Bankers will possibly make (certain) clients pay them a periodic compensation for the safe custody of money (subject to deposit protection)—at least for accounts that are not regulated. Certain banks already do that today with respect to certain corporate clients.
In the light of these developments, the traditional legal characterization of the current and savings accounts will probably need to be reconsidered.
A bank account agreement is traditionally considered to be a “sui generis” contract. In order to find practical solutions, courts usually tend to refer to aspects of other more established contract forms such as agency (“mandaat” / “mandat”), loan for consumption (“verbruiklening” / “prêt de consommation”) and custodianship (“bewaargeving” / “dépôt”). Typically, most emphasis is put on the loan characterization and less on the custody aspect (also because custody typically requires the custodian to safeguard the exact asset entrusted to it whereas money that is entrusted to the bank is entirely fungible). However, it goes without saying that if the bank charges the client periodic compensation (the so-called negative interest payment) for the service of safekeeping money, the similarities with a “loan for consumption in return for interest payment” become a lot less self-evident where: (i) the lender owes the borrower interest payment on the sum of money lent out (and not the other way around), and (ii) the bank’s motive to conclude the agreement does not necessarily consist of the possibility to use the lent-out sum for its own purposes (cf. the current abundance of liquidity). Characterizing such an arrangement as a modified type of custodianship (i.e., fungible funds in custody result in a debt to repay an equivalent amount) becomes much more convincing. Clearly there is a need for a shift in the analysis to accommodate the changing market environment.
In relation to contracts that are in force today, it seems one must be careful with unilateral adjustments so that one can deal with the inverted interest rates. Examples from abroad prove that bankers cannot always count on the courts’ understanding when they rely on or invoke the clauses in their banking terms and conditions that allow for interest rate adjustments. For example, one court held that banks may not rely on such a clause to impose a zero-interest rate for consumer savings accounts. The legal doctrine of unfair terms, inter alia, was applied to the case’s assessment to conclude that clauses allowing such a zero-interest rate are manifestly detrimental to the consumer and are therefore null. Reference is also made to the essential objectives of a savings account, i.e., to generate income and build up assets.
Does the aforementioned evolution mean that in the future we will no longer be able to characterize a credit agreement as an agreement that the lender enters into for granting a loan in return for consideration payable by the borrower? Most authors who have looked into this question seem answer this in the negative. They say that a credit agreement remains an agreement whereby the borrower pays compensation to the lender as consideration for the latter’s provision of money or creditworthiness, and that any temporary suspension or even reversal of the compensation should not alter the essence of that agreement.
This does not mean that legal counsel can ignore the new context. In credit agreements with a variable interest rate, the interest payment is usually made up of the sum of a variable reference interest rate (Euribor, Libor, …) and a (positive) fixed margin (x base points). As of now, one must keep in mind that the reference interest rate can be negative and can lead to a globally negative interest. Legal counsel will therefore have to add a floor (zero minimum) with regard to either the reference interest rate (i.e., the reference rate may never drop below zero, so the interest formula will always yield a positive margin) or the interest formula itself (i.e., the interest formula will always yield at least zero, in which case the margin is lost).
The question of how banks have to deal with credit agreements that are in force today and that include a variable interest rate formula without a floor, has as far as we know not yet been answered by any Belgian court. Can banks rely on or invoke their credit conditions to impose a floor unilaterally? The interest rate adjustment clauses that typically appear in those conditions often only allow the lender to change the reference interest rate and/or to unilaterally change the margin level. Does such a clause also allow the lender to unilaterally change the interest rate formula afterwards if it states that the chosen reference interest rate or the result of the formula may never drop below zero?
If the bank does not (or cannot) change the interest rate (formula) unilaterally, can it still assert that it can never find itself in a situation where it, as lender, will owe the borrower interest payment?
Although one will always need to analyse the particular wording of the credit agreement, we think that there are—in a lot of cases and based on how this type of agreement should be construed—a number of valid arguments that can support that assertion:
- First of all, in practice: loans and credit agreements reflect the characteristics of a traditional, standard concept of a loan or credit (sometimes set out by law) in such a way that the parties, at the time of entering into the agreement, could be deemed to want to conform to such concept (as translated e.g. into Articles 1905-1907 Civil Code regarding loans in return for interest, on the condition that the borrower pays the interest).
- Then there are the fundamental economics of a credit transaction: the intent to allow another party to temporarily benefit from the use of money in return for paying compensation (to the lender). If one accepts that a client (or consumer) seeks profit from having savings (see above), then should this not be the same with regard to the money that the bank lends to its borrowers by way of a credit agreement?
- Furthermore, the legitimate expectation of the parties to the credit transaction: the client must assume that the lender seeks to obtain a certain profit margin from the transactions on the credit granted (according to certain foreign authors, the borrower therefore always pays the margin in the event of a negative reference interest rate).
It follows from foreign case-law that the arguments supporting the opposite thesis are not without merit either. In Austria, the Netherlands, as well as in France, courts have decided not to side with the credit institutions if the latter unilaterally introduced a floor regarding the reference interest rate without there being a clause in the credit agreements allowing for this. These cases often concerned credit facilities in foreign currencies that were granted to consumers.
Interest rate swaps
The phenomenon of negative interest rates also greatly affects derivatives, especially interest rate swaps. A lot of corporations and public bodies use these instruments to hedge against the risk of a variable interest rate increase that applies to some of their financing instruments: the swap obliges them to pay a fixed interest rate to the bank, whereas the bank commits to paying the variable interest to the client-borrower. However, if the variable interest rate of the financing instruments turns negative, the client can find himself in the situation where he pays the bank both the fixed interest rate and the negative variable interest rate under the swap. In such scenario when the client-borrower cannot make the bank pay the negative interest rate under the credit agreement, he pays both the fixed and the variable interest to the bank.
Without a statutory solution, the legal position will first of all depend on the contractual conditions of the swap, which are usually governed by ISDA-documentation. The most commonly used ISDA Definitions (especially from the version dated 2006) describe how a variable interest amount (a “Floating Amount”) payable by a party should be calculated if the relevant interest rate is negative. This depends on the choices made by the parties to the agreement. If the parties specify that the so-called “Zero Interest Rate Method” will apply, then the Floating Amount will be considered zero (which means that the party that is normally obliged to pay the floating interest rate is discharged from the payment obligation). If the parties did not agree to apply the aforementioned method, then the “Negative Interest Rate Method” applies automatically. According to this method, the Floating Amount will not be considered zero, but it will entail the obligation for the other party to pay—on top of its own payments—the absolute value of the negative Floating Amount. As the negative interest rate environment is a relatively recent phenomenon, many parties on the market who are bound to older swap agreements would not have given (sufficient) attention to this.
In litigations whose subject matter is derivatives, banks are often faced with the discrediting fact that they have not sufficiently informed or advised the client about a possible mismatch between the credit agreement and the derivative (regarding the duration or the scope of the hedge). The negative interest rate environment now presents a threat of lawsuits regarding another mismatch: the one between the fate of the negative interest payable under the credit agreement and the one payable under the swap. For swaps concluded after 1 November 2007, one must also take into account the MiFID-rules. Although one cannot generalize the analysis and must take into account the particular circumstances that may apply, one can say that the negative interest rate environment that took place surrounding the transactions concluded before the beginning of 2014 was a genuine surprise for most market participants. Indeed, the reference interest rates’ drop below zero is closely connected with the decision of the ECB dated 5 June 2014 in which the ECB held that a negative interest rate should be applied for the first time in its history to its liquidity surplus that banks deposit with the ECB. As is widely known, that tariff is to be considered as the benchmark for the “cost”, and indirectly the “profit”, of money. One should therefore, in our opinion, not criticize those banks by saying that they did not foresee this evolution and did not take this into account at the time they were informing and advising the client.