Today’s announcement about Barclays being fined £290m is extremely important news – especially for firms that have interest rate swaps with Barclays and other Banks that are also involved in this manipulation. In fact, this could have larger ultimate consequences for the Banks involved, than even the impending formal FSA investigation likely to be announced within 48 hours.
The importance is not because of the size of this fine, or the fact that it is the largest ever by the FSA – in fact, Barclays won’t even notice this amount it has to pay.
The much more critical issue (which is far more damaging) is that the Bank has admitted liability for manipulating LIBOR. As has been reported, LIBOR (and its associated equivalents for various currencies) are one of the bedrocks of our entire financial system. Residential mortgages, company loans, deposits, inter-bank borrowing, and of course derivatives are all based on it.
It is this issue of derivatives that is the most worrying. It is difficult to estimate the trillions of amounts involved in derivatives in the global market.
How does this affect a small business who has an interest rate swap with their Bank?
At this stage, to be very clear, we are exploring the potential implications of this news. We do not know for certain the extent of this manipulation, how many banks were involved, or how this may impact legal claims to do with interest rate swap mis-selling. A large part of this belongs in the realms of solicitors and barristers, but we express our view as points to consider only.
Let us look at 3 simple scenarios:
1.Business has a LIBOR loan and a LIBOR hedge
In this situation, the Bank may argue that if LIBOR was moved artificially higher or lower, this should have no net difference on the overall client’s position, since the hedge and variable-LIBOR rate borrowing will offset each other. This of course is only even applicable where the loan term and hedge match perfectly, and as we have seen in the dozens of cases we are advising, there is often a mis-match between the borrowing and the hedge. In fact, we have seen many cases where the hedge is larger or longer than the borrowing, which of course means that the business is potentially even more vulnerable to LIBOR manipulation.
However, this potential defence from the Bank also misses the point, that the Banks are often defending their sale of derivative products by saying that the hedge is a completely independent transaction – which of course it is. In which case, if one part of the Bank has been knowingly manipulated the index that the hedge is based on with another part of the Bank, then one could argue that the contract becomes null and void in its own right.
2. Business has a Base Rate loan and a LIBOR hedge
In this situation, it is easier to see why there could be a big cause for concern by the Banks. We have seen that in many cases, Banks have not advised businesses about ‘basis-risk’, that is, having borrowing against one index (say Base Rate) and having it hedged using another (say LIBOR). This potentially exposes the client to a further risk that the indices move away from each other, causing a further mis-match in payments under the hedge. If LIBOR was artificially lowered, then it could mean in the credit crunch-times when LIBOR spiked to high levels, the Bank should have been making more payments to the business under the LIBOR hedge than it actually did. Again, this could mean huge sums of interest being owed to businesses.
3.Business has a Base Rate loan and Base Rate Hedge
This is potentially more relevant for SMEs. Even though an SME may have a Base Rate Hedge, they could still be affected by this LIBOR manipulation. How?
There is no Base Rate hedging market in the UK per se. When the UK Banks provide a Base Rate hedge, the Bank’s traders make an internal adjustment / calculation of the value of the hedge by making a comparison to the prevailing LIBOR rates. This is even more so, with complicated products such as Asymmetric Leveraged Collars, or Collars with Double Knock-In Floors for example (often favoured by Barclays as it happens). These very complex products would often have to be priced against 1 Month LIBOR for example as a proxy. Hence, SMEs could also be affected by this news of LIBOR manipulation, since their actual hedge is affected by movements in LIBOR.
A defence by the Bank’s could be that they did not intend to manipulate LIBOR to affect interest rate derivatives, but this is something that the Solicitors will no doubt challenge with the Banks.
Again, to be clear, it is too early to identify or quantify the actual impact of this issue on businesses that have interest rate derivatives, and we are not saying that the above arguments will be successful.
However, we feel that this could be an issue with catastrophic implications for the Banks involved, far more so than the FSA investigation into swap mis-selling. This is because the FSA investigation is likely to be focussed on SMEs (again we don’t know this for sure), but LIBOR manipulation affects some of the largest businesses in the world. We have clients who have borrowings with the Bank of c£250m who could be affected by this.
This is especially so as the names of more Banks emerge, such as Bank of Scotland, RBS and HSBC which would of course cover the vast majority of interest rate hedges sold in the UK between 2005-2009.
A lot more technical and legal analysis will be required in time to come which we will of course help Solicitors, Barristers and Clients with.