Hedging Bets Municipalities At Risk from Negative Interest Rates

Local authorities tend to be cautious with their money, and have set up various hedges to protect their finances, but negative interest rates mean they could be exposed to far more risk than they realise.
Local communities are battling with the banking towers in the background.

German municipalities may be unwittingly exposing themselves to huge monetary risks: The financial instruments they use are not geared up for the kind of negative interest rate environment that Europe is currently experiencing.

The German Association of Cities has warned local authorities that they may be exposed to "theoretically unlimited risk," in a letter written in March and seen by Handelsblatt.

Ironically, the new risk actually stems from a cautious approach taken by many local communities. Many engaged in hedging deals in the past years to protect themselves from interest-rate fluctuations.

The trouble is that these are not really geared up to deal with the current monetary policy of the European Central Bank, which last year began pushing some interest rates in the 19-nation euro zone into negative territory for the first time in its history.

Ordinarily, German city and town treasurers benefit from a low interest-rate environment, because it reduces their borrowing costs. However, municipal governments often take out variable interest-rate loans and try to hedge against rising rates with swap transactions.

The problem is that banks now bill each other for negative interest rates in their deals with one another. Many swap transactions are based on these reference rates. The result is that the construct, intended as a safeguard, could turn into a cost trap for cities and towns.

German municipalities have about €52 billion ($59 billion) in credit on their books, and they are often hedged with swaps. In these arrangements, a bank lends money to a city, while another bank provides what is typically an insurance mechanism. The trouble is that this insurance may now turn into a major cost.

Municipalities should not accept being placed at a disadvantage because of negative interest rates. Jan Hartlieb, Sachsen Asset Management

This is how these dual arrangements work: The municipality takes out a loan from Bank A and pays an interest margin, which is usually small, plus the Euribor rate, which is reset daily. Euribor is the interest rate at which banks lend each other money. At the same time, the city enters into a swap transaction with Bank B (although it could also be Bank A again). The municipality pays Bank B a fixed interest rate and is then reimbursed for the Euribor rate.

However, Euribor, as a reference interest rate, is now negative, thanks to the monetary policy of the European Central Bank. Since last year, the central bank has been effectively charging banks fee if they park excess customer funds with the central bank, instead of paying them interest on the deposited funds. In March, it raised that fee to 0.4 percent.

For municipalities, this means that because the Euribor has now slid so clearly into negative territory, it often eats up Bank A's interest margin. In theory, that means the municipality ought to receive money from Bank A. But to avoid this payment, bank are setting the Euribor rate to "zero." In doing so, it may be invoking Section 484 of the German Civil Code, under which borrowers are obligated to "pay interest owed" – and some banks believe that this interest cannot be negative.

The municipality, however, has no such luxury: It's still supposed to pay Bank B a fixed rate, along with the Euribor rate that is now negative. The result: An expected reimbursement has turned into a cost. The bottom line for the municipality is that it suffers a double disadvantage because of the ECB's negative deposit rates.

This has prompted some municipalities to seek legal advice after a German trade publication, “Der Neue Kämmerer” or The New Treasurer, first reported on the issue.

János Morlin, an attorney with the Rössner law firm in Munich, which was hired by a dozen municipalities, said that there is "uncertainty on both sides."

Jan Hartlieb, managing director at money managers Sachsen Asset Management, says the communities need to be more aggressive in talks with their banking partners. He said he has noticed an uncertainty among banks that can be exploited in negotiation talks.

"Municipalities should not accept being placed at a disadvantage because of negative interest rates," said Mr. Hartlieb, who is discussing the issue with several of those affected.

According to the letter from the German Association of Cities, banks are handling the situation in various ways.

"Even though payments resulting from the negative interest situation may be manageable in individual cases at the moment, the threat must be taken seriously," the letter reads.

The association recommends that municipalities broach the topic with their banks, so that the "intended hedging function" also functions in the current negative-interest environment. It also recommends that, in certain cases, municipalities simply withhold a portion of the payments from the swap and, if necessary, clarify the issue legally.

The Association of German Banks, which represents private commercial banks, and the Association of German Public Banks (VÖB), have not commented on the actions of banks.

"The prolonged low-interest phase, which leads to negative rates in some cases, presents established products with new issues and case configurations," the VÖB said in a statement, adding that it supports the recommendation by the German Association of Cities that municipalities seek a solution together with their banks. "The private banks are prepared to have these conversations."

In the future, banks and their customers will likely contractually regulate how negative reference interest rates are handled. However, some observers expect the current contentious cases to be decided by courts.

"I think there will be legal disputes sooner or later," said Wolf Bussian, a partner with the law firm of Allen & Overy.

Municipalities in Switzerland, which also has negative reference interest rates, have also already hired law firms. Some cantons have already been asking citizens to pay their local authority bills as late as possible, so the canton does not have to bear the costs of holding money in their bank accounts.

In Austria, there have already been court decisions in similar cases, with the lower courts deciding in favor of the bank's customers. Under those decisions, banks must pass on negative reference interest on foreign currency loans to their customers, in this case private citizens. In other words, they either pay less for their loans or receive an interest credit. However, a decision by the country's highest civil court is still pending.


Elisabeth Atzler is the banking correspondent of Handelsblatt. To contact the author: [email protected]