Questions for loan market to answer on 'cost of funds' fallbacks as LIBOR replacement

Out-Law Analysis | 06 Nov 2019 | 11:12 am | 3 min. read

LIBOR, a widely used benchmark for setting loan interest rates, is expected to be discontinued by 2022. Lenders may be considering relying on any 'cost of funds' fallback included in their documents to calculate interest from this time.

These fallbacks allow a lender to calculate interest based on the cost to it of funding the loan. Lending documents typically do not provide guidance on how cost of funds should be calculated, injecting a level of uncertainty and therefore risk of challenge where lenders seek to rely on it.

The Courts have interpreted 'cost of funds' provisions in various contexts, but the provisions can still be interpreted in different ways. It is therefore instructive to apply English law principles of contractual interpretation and ask what a reasonable person would have understood the parties to have meant.

For 'cost of funds' the answer to this may have changed over time. Historically, lenders funded their LIBOR lending activity to a greater extent through the London interbank loan market. So a reasonable person might have the understood that the cost of funds fallback referred to the cost to the lender of borrowing the funds on a matched funding basis on the London interbank market.

However, the proportion of funding provided by non-bank lenders, which may not fund themselves at all on the interbank market, has increased, and in general the volumes of loans funded through the London interbank market has decreased. Add to this the expected discontinuation of LIBOR and the context seems to demand a broader interpretation of the 'cost of funds' fallback.

Three ways it could be defined are:

  • the cost to the lender of funding the relevant amount by borrowing the relevant amount, whether actually or hypothetically;
  • the average cost to the lender of funding all its assets by whatever means, including equity; and/or
  • the cost to the lender of carrying an asset on its balance sheet, taking into account the impact on its equity capital in light of the nature and riskiness of that asset.

Which of these are likely to be what the reasonable person understood the 'cost of funds' fallback to mean?

The carrying cost of an asset (the third option) seems to depart from the philosophy which underpins loan market pricing. Instead of calculating interest by reference to the cost to the bank of funding the loan plus a margin, this methodology requires an assessment of how costly it is to the bank to hold the asset, a cost the lender arguably should have compensated itself for by the margin it charges.

The actual cost to the lender of borrowing the relevant amount, whether on the London interbank market, the capital markets or elsewhere, is perhaps the most straightforward construction. But this suffers from the practical challenge that not all lenders fund their activity wholly or partially by borrowing, and to the extent they do, such a methodology may require isolating which borrowing transactions relate to which funding activity.

The average cost to the lender of funding the loan taking into account all its funding sources has the benefit of being empirically calculable, but suffers from disclosure of what might be considered commercially sensitive information, and use of resource in calculating, and possible compounding, a rate that may vary from day to day and communicating that to administrative parties and borrowers. Leaving aside what might be considered the borrower's understanding of a cost of funds provision, a lender might well claim that this would not have been a reasonable person's understanding of the provision.

This then leaves the hypothetical cost to the lender of borrowing the loan. Where cost of funds fallback provisions do not specifically provide for a calculation based on a hypothetical transaction – meaning what the cost to the lender would have been if it had, for example, funded the loan through borrowing - arguably the fallback requires an actual transaction undertaken by the lender.

Such a construction could be seen as unduly narrow – where lenders are not financing their lending on the London interbank market, the use of LIBOR in contracts is already a notional exercise. It might therefore be possible to argue that a cost of funds fallback calculation could also refer to a hypothetical transaction, and that such an interpretation might be the conclusion that the reasonable person could reach.

These are some of the considerations that lenders will need to consider before relying on any 'cost of funds' fallbacks in their lending documents.