On 20 January 2022, the National Bank of Serbia ( the “NBS”) published the Recommendation in Connection with the Interest Rates which Would Replace Benchmark Interest Rates which Cease to Apply (CHF LIBOR and EONIA) (the Recommendations). The aim of the Recommendations is to ensure uninterrupted continuity of the contractual relationship between the borrower or the deponent and the bank following cessation of CHF LIBOR and EONIA.
As part of the ongoing global reform of benchmark interest rates, CHF LIBOR and EONIA (among other benchmarks) ceased to be published as of the beginning of 2022 by their respective administrators (ICE Benchmark Administration and the European Money Market Institute). This resulted in a need to introduce new mechanisms for calculating the interest rates in all loans and other agreements in which the variable interest rate was determined by reference to CHF LIBOR and EONIA. Due to the significant amount of legacy contracts based on CHF LIBOR and EONIA in the European Union, to preserve financial stability the European Commission enacted in October 2021 two regulations (nos. 2021/1847 and 2021/1848, the “EU Regulations”) by which it prescribed statutory replacement rates for all relevant contracts which were based on these benchmarks and where the parties did not agree to an adequate replacement. The SARON compounded rate publicized by SIX Swiss Exchange was determined as a replacement rate for CHF LIBOR and €STR, a new Euro overnight rate administered by European Central Bank, was determined as a replacement for EONIA.
Although in Serbia overall amount of contracts based on these benchmarks is not significant, especially due to the earlier enactment of the Law on the conversion of housing loans indexed in CHF, there is still a need to resolve these legacy contracts and ensure their continuity, which the Serbian regulator has correctly recognized and reacted by issuing the Recommendations. The Recommendations relate to two types of instruments – loans and deposits, which is presumably a result of the assessment that these two groups of contracts are most relevant to address in the Serbian market. Following the approach taken by the European Commission, the NBS recommended to Serbian banks that, in case no other mechanism for this situation is agreed, an offer to enter into an amendment to the loan agreement should be made to the borrowers with which variable interest rate by reference to CHF LIBOR or EONIA has been agreed, whereby: (i) CHF LIBOR (1M/3M/6M/12M) would be replaced with an appropriate compounded term structure (1M or 3M) of SARON rate with spread adjustment value, and (ii) EONIA would be replaced with €STR rate with spread adjustment value. The replacement rates are recommended to be used as set out in the EU Regulations, which in the case of CHF LIBOR means that a standardized compounded SARON of 1 or 3 months tenor as published by SIX Swiss Exchange is used, whereby such rate is calculated for the period immediately preceding the relevant interest period under so-called “last reset” methodology. This approach is taken to enable the use of the benchmark rate which is known before the start of the relevant interest period, as otherwise compounded value of overnight SARON can be calculated (and known) only at the end of the respective period.
It is also recommended that: (i) the borrowers are offered a possibility to, instead of replacing one variable interest rate with another, choose that the latest published CHF LIBOR or EONIA continues to apply until the repayment of the loan, i.e. that it applies as a fixed interest rate, and (ii) this mechanism is applied in case a borrower does not enter into the abovementioned amendment nor it terminates the loan agreement. This “fixed” alternative is a local feature, which seems to be suggested in the interest of simplicity for this limited amount of contracts and having in mind current negative values of benchmark rates which are favourable for the loan users. From banks’ perspective, it means a shift from an instrument based on a changeable rate to a fixed-rate instrument, which requires adequate managing of financial risks, in particular asset and liability management.
As for the deposit agreements, the NBS recommended that the banks apply going forward the abovementioned replacement benchmark interest rates, i.e. compounded SARON with spread adjustment value and EONIA with spread adjustment value, unless the deponent refuses the application of these interest rates and terminates the agreement.
As the NBS provided the guidance, Serbian banks are now expected to prepare model fallback clauses in order to provide their clients with the abovementioned offers. While the NBS provided helpful substantive guidance, which comes among the first in the non-EU countries in the region, fallback clauses still need to be carefully drafted to address all relevant details to enable the proper functioning of contracts going forward. This is particularly impacted by inherent differences among the manner of calculation of new compounded overnight rates, which are in their nature backwards-looking, and LIBOR as a forward-looking rate. For instance, one of the questions which fallback clauses will need to address is how exactly the standardized compounded rate of 1 or 3 months will be applied when the actual next interest period in the loan turns out different from the previous “observation period” based on which SIX Swiss Exchange calculated the standardized compounded rate, in particular when the actual period turns out shorter either due to the difference in calculation of business/calendar days or due to period break in prepayment.
It is also worth noting that, in addition to CHF, LIBOR rate ceased to be published from 1 January 2022 also for other world currencies – GBP, EUR and JPY for all tenors and USD for 1W and 2M tenor (while other USD tenors are set to be discontinued from 30 June 2023). This means that replacement clauses are required also for the contracts based on these other LIBOR settings. Due to the limited amount of legacy contracts based on these other terminated benchmarks, they are not covered for now by the NBS Recommendations, similarly as the European Commission did not prescribe any statutory replacement rates for such cases. Still, there are comprehensive guidelines for the contractual transitions of each of these benchmarks provided by official working groups in each of the respective currency benchmark centers, which should be taken into account as the best international practice. Such private contract solutions need to reflect also local law requirements, especially in the area of consumers protection, as well as the circumstances of each institution and its clients, which makes the process inevitably complex.
On the other side, EURIBOR as the benchmark which is dominantly used for foreign currency instruments in the Serbian market was, to everyone’s relief, successfully reformed by its administrator (European Money Market Institute) and for now is not set to be discontinued. Still, its long-term future is uncertain and the EU rules require financial institutions in the EU to embed in their relevant contracts based on EURIBOR robust fallback clauses, providing for a replacement rate which would apply in case of permanent cessation of EURIBOR or its loss of representatives. Although Serbia is not yet part of the EU and these rules do not apply formally to institutions here at the moment, alignment of local rules with the acqui in this area is planned as a part of the EU accession process. Fallback clauses are also a matter of risk management and as such need to be considered by each institution, which is particularly emphasized for the institutions which operate within an international group where other group members are already subject to direct regulatory requirements in this respect. Since the amount of new contracts accumulates daily, it is reasonable to expect that the overall process will be easier for the institutions which manage to develop adequate fallback rates sooner than later.
If you have any questions related to this article, please do not hesitate to contact:
Maja Jovančević Šetka, Partner
Dimitrije Ilić, Associate
*Partner and Associate refer to Independent Attorney at Law in cooperation with Karanovic & Partners
The information in this document does not constitute legal advice on any particular matter and is provided for general informational purposes only.