Source: KPMG Corporate Treasury News, Edition 40, February 2015 Low interest rates have become an issue ever since several banks introduced 'penalty interest' on account balances. The situation affects more than just how to invest funds or where to park short-term liquidity. The 1M Euribor rate temporarily dropped below zero at the start of the year, and the 3M Euribor is not far from it.
This could have considerable impacts on existing and future transactions:
Especially in recent lending, banks are taking measures to avoid having to pay out if interest rates turn negative. Contracts stipulate that the fixed Euribor interest rate cannot fall below zero. This means the loan has a floor. IAS 39 AG33 (b) requires a review to determine whether the floor must be accounted for separately, as will be the case if the relevant interest rate is already negative when the transaction is closed.
Interest rate swaps
Many companies have interest rate swaps in their portfolios whose variable side is based on Euribor. When variable-rate loans are hedged, the company receives variable interest from the swap. Depending on how the contract is structured, this could mean the company receives cash flows from both the fixed receiver leg and the variable payer leg. If a treasury system is used for automatic posting, therefore, the company should check to make sure the set of transactions is correctly posted.
If the grouping of a variable-rate loan with an interest-rate swap is accounted for as a cash flow hedge under IFRS, its effectiveness in practice is often close to 100%. If the loan contains a clause that precludes negative interest rates, however, and the swap contract is missing the mirror image of this clause, ineffectiveness can quickly result. The prospective effectiveness measurement can even lead to dedesignation of the hedge. This is because, given the current level of interest rates, a scenario in which rates fall below zero may be assumed likely and cannot be ruled out per se. The hypothetical derivative, however, must contain a floor analogous to that in the underlying transaction.
Disclosures in notes
Among other things, IFRS 7 requires disclosure of the extent to which an entity is affected by changes in interest rates. Naturally, this means it must know which loan contracts contain a floor. It often turns out that all contracts must be inspected to be sure. At that point calculating the interest rate sensitivity of loan contracts manually is quickly accomplished. Revaluations of derivatives in treasury systems with shifted interest rate curves to determine interest rate sensitivities, however, must be carefully reviewed to ensure that negative interest rates are properly taken into account.
Author: Andrea Monthofer, Manager, firstname.lastname@example.org
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