The discontinuation of LIBOR, announced for the end of 2021, is foreseeable. At the same time, for lack of suitable alternatives, LIBOR is still the dominant reference rate in the Swiss retail lending market for floating rate borrowings. As a result, Swiss banks active in the mortgage lending market already now face the challenge to provide for a transition to a successor rate when entering into new contracts. And the same challenge exists generally, both in the retail and the institutional market.
By René Bösch / Benedikt Maurenbrecher (Reference: CapLaw-2019-04)
It is estimated that in Switzerland currently LIBOR related mortgages amount to approx. CHF 150 billion. Quite many of these mortgages have a term of 3 years or more, which means that more and more of such mortgages coming up for renewal should address the expected discontinuation of LIBOR during the term of the renewed mortgage. Internationally several organizations such as the International Swaps and Derivatives Association (ISDA), the Loan Market Association (LMA) or the Alternative Reference Rate Committee (ARRC) have been working on proposals for model clauses addressing the replacement of LIBOR, but all these efforts were focusing on the institutional markets. Various proposed model LIBOR replacement clauses have been developed under the auspices of these organizations, but because of their complexity these model clauses are not suitable for the Swiss retail market.
In Switzerland the National Working Group on Swiss Franc Reference Rates last year proposed the Swiss Average Rate Overnight (SARON) as new reference rate for Swiss franc denominated lendings. This rate is determined on the basis of historic overnight transactions in the Swiss repo market, but in contrast to LIBOR it is an entirely risk-free rate with a one-day term only. Therefore, for an economically neutral switch from LIBOR to a new reference rate in the Swiss franc lending market, SARON as such is not suitable as a successor rate. Rather when using SARON as basis for such purposes, an adjustment must be made.
Under Swiss law a few fundamental elements of contract law should be considered when developing a successor clause for LIBOR in the retail lending market: Firstly, the parameters for a switch from LIBOR to a new reference rate need to be as clearly specified as possible. Quite obviously, this poses a significant issue at a time when neither the when nor the how of the discontinuation of LIBOR are known. Second, it would be preferable to accept a successor clause that has been developed by an independent third party and has received, or is about to receive, widespread or even universal acceptance in the markets – only to acknowledge that currently we are far away from such situation having materialized. Thirdly, the switch from LIBOR to a successor reference rate must not put the customers at an undue disadvantage, meaning that it should be as economically neutral as ever possible and not be used by banks / lenders to achieve an economic benefit. And finally, the contractual clause regulating the succession of LIBOR should be as easily readable and comprehensible as possible.
Having faced these challenges, last year we developed an idea how a LIBOR successor clause could look like for the Swiss retail lending market. The aim was to craft a simple, easy-to-read clause for retail clients that provides for a fair transition to a successor rate. The clause is embedded in well established principles of Swiss law. On 31 October 2018 we presented a proposed clause, together with a few underlying considerations, to the National Working Group on Swiss Franc Reference Rates on October 31, 2018 – in German and French, with an English translation.
The LIBOR replacement clause developed by us focuses on two key elements:
– Trigger – when will LIBOR be replaced?
– Waterfall – how will LIBOR Replacement Rate be determined?
As regards the trigger, the “discontinuation” of LIBOR, we came to the conclusion that no hardwired formulation is possible today because of the many uncertainties still existing. The approach taken by the international organizations, refering to official announcements of regulators or sponsors etc., did not seem appropriate to us because of the complexity of respective formulations. Accordingly we found it easier to simply refer to either a situation when the relevant Swiss Franc LIBOR is not longer available as a recognized reference rate or is no longer published. Admittedly, the respective formulations are rather open ended, but we trust in a meaningful interpretation of these wordings by market participants and their advisers on the basis of concrete factual circumstances at the time.
For the consequences of the disappearance of LIBOR we came to the conclusion that the most suitable approach to deal with existing circumstances would be a “waterfall provision”:
– Firstly, the reference rate that is economically as equivalent as possible and quoted by a third party should be chosen.
– Secondly, if no such reference rate is available, we propose to rely on an add-on (which can be a positive or negative number) calculated and published by a third party with a view to bridge the gap to a new (un-)equivalent reference rate such as SARON.
– And thirdly, if neither a new third party reference rate nor a third party add-on is available, the bank shall calculate the relevant addition | deduction itself and apply such add-on in determining the new interest. Banks not prepared or equipped to take on such task could alternatively fall back on the historical levels of LIBOR prior to discontinuation, adjusted for developments in interest rates for the relevant duration since discontinuation.
Based on these considerations we have developed the following model clause that market participants may consider for the retail lending market:
- In case that CHF-LIBOR [is no longer available as recognized reference rate | is no longer published], the parties agree that BANK will determine the interest rate on the basis of another reference rate that is economically as equivalent as possible. Equivalent may in particular be recognized reference rates that are calculated with a view to provide a value-neutral replacement for CHF-LIBOR denominated loans.
- Is no such an equivalent reference rate available from a third party, and there neither is a recognized addition or deduction for an economically neutral replacement of CHF-LIBOR published, then [Alternative A: BANK shall itself determine such addition | deduction and apply it in fixing the new reference rate.] [Alternative B: the new interest rate will be determined by reference to the [average] [median] historic CHF-LIBOR rates for the last bank working days prior to the discontinuation of CHF-LIBOR, adjusted to reflect the general fluctuation of the interest rate level since the discontinuation of the CHF-LIBOR.]
- The new reference rate will be applied for the first time for the immediately following interest period. Should the disappearance of CHF-LIBOR time-wise be very close to the commencement of the immediately following interest period, BANK may utilize [for such next interest period | for a next interest period with a duration to be determined] an interest rate that is based on the last available CHF-LIBOR rate.
Whatever language will be chosen by banks in the Swiss retail lending market, it will be imperative for banks and other lenders to actively and transparently communicate the manner in which they propose to manage the switch from LIBOR to a successor reference rate.
René Bösch (rene.boesch@homburger.ch)
Benedikt Maurenbrecher (benedikt.maurenbrecher@homburger.ch)