We use cookies on our website to enhance your browsing experience. By continuing to use this site without changing your settings you consent to our use of cookies in accordance with our cookie policy. To learn more about cookies, how we use them on our site and how to change your cookie settings please view our cookie policy.

Close Cookie Bar

What have we been up to


Donec varius pellentesque metus, at vehicula magna egestas quis. Sed purus ipsum, vehicula id libero laoreet, posuere ornare urna. In eu nulla leo. Nullam pellentesque dolor nec scelerisque consequat.

Ring-fencing: the unintended consequences…continued

Share on Linkedin
+ -
If you thought this page is useful to your friend, use this form to send.
Friend Email
Enter your message

This article concerns embedded hedging - where the inflation linked hedge has been embedded into the underlying facility agreements, or where this is provided for under the facility agreement. It does not apply to standalone derivatives or hedging contracts governed by ISDA agreements.  

In a previous article, published on 12 February 2018, we outlined a case study involving a Housing Association client of JCRA who was facing something of a ‘Hobson’s choice’ in dealing with legacy inflation-linked hedges.  

At the time of publication, the borrower and lender in our case study had not reached an agreement on the way forward.  As the deadline for the implementation of ring-fencing rapidly approaches (it becomes law on 1 January 2019), the situation is yet to be resolved to the satisfaction of either party. The bank in question has received different external legal advice to other lenders to the sector. Consequently, there is inconsistency in the approach of banks to this issue and other lenders are not requiring borrowers to take action in respect of these hedging instruments. We are now speaking with several clients across the UK who have been caught up in the same situation.

The alternatives for Housing Associations with inflation-linked loans are not borrower-friendly:

Any inflation-linked hedges or loans, or any loans which allow the borrower to ‘fix’ using an inflation rate will be moved to outside of the ring-fenced bank unless:

  1. The borrower has not drawn any of their loans with an inflation rate reference and signs a waiver letter acknowledging they will never hedge/fix on this basis in future
  2. The borrower terminates the hedging at the total MTM (Mark-to-Market or breakage) cost at the date of termination. The bank’s position is that they have no capital/reserves held against these embedded derivatives and therefore no incentives are available on early termination. Note this does not result in the repayment of the underlying debt, just the termination of the embedded inflation derivative. The amount of debt covered by the inflation instrument will revert to the floating interest basis set out in the underlying facility agreement
  3. The borrower converts the inflation-linked hedge to an interest rate hedge, with the total MTM cost embedded into the restructured hedge, resulting in a higher fixed rate than would otherwise be payable


Implications for the loans transferred outside of the ring-fence:
This course of action has been presented to borrowers in rather stark terms.  Housing Association loans moved to the investment bank are likely to be considered ‘non-core’.  This means that the loans are unlikely to be actively managed by the bank and may be ‘run-off’ - a euphemism for sold to another funder.  

While the bank is suffering costs on a macro level (capital/funding) if the loans are transferred outside the ring-fence, the fact that these costs are not incurred until or unless the loans are transferred creates a catch-22 for the borrower.  

The current position is that no incentives are available for borrowers under a restructure or termination if the hedging remains in the ring-fenced bank. No provisions will have been made against these performing loans – this is not a “work-out” situation as in the case of many commercial property real estate loan books in the immediate aftermath of the credit crisis of 2008/09.  However, if the borrower does not restructure or terminate the inflation linked embedded hedge, the loans and hedges will be moved outside of the ring-fence and they risk the loan being sold to a fund/alternative lender and potentially will face their long-dated funding being repriced or altered by another lender.  This is an unquantifiable and significant risk.

Hobson’s choice:

The borrower can either (at their full cost) terminate or restructure their inflation-linked hedge or can allow it to move outside the ring-fenced bank and face the potential of facing an unsupportive lender and/or the sale of a loan to a new lender who may change the lending term and pricing.

The bank’s current position is that they will not contribute any costs to the borrower to either restructure or terminate the hedging. Their argument is that the regulator is enforcing this change; not the bank.  Their legal advice is that any inflation-linked hedging needs to be transferred outside of the ring-fenced bank. While the bank is taking the administrative and capital costs associated with the ring-fencing exercise (which are not inconsiderable), on a client level, it is the bank’s position that the costs of this regulatory-enforced change are to be borne exclusively by the borrower.  Furthermore, we are aware of instances where the bank has at least initially stated that if there is one inflation linked loan within a borrower’s portfolio then potentially the whole relationship (i.e. including other loan outstanding to the borrower) will have to move outside the ring-fenced bank.

Where to from here?

The deadline for implementation of ring-fencing has less than six months to run and the unintended consequences of this legislative change on social housing organisations with embedded inflation-linked hedges are significant.

For borrowers in the social housing sector, the political fallout in the event that legacy loans and embedded hedging are sold to alternative lenders (which may include hedge funds) as a result of ring-fencing is unlikely to be well received by the UK public.  Housing Associations have a mandate to provide affordable housing, which is politically sensitive issue.  Lenders are likely to be within their legal rights to sell, transfer or assign a loan but the prospect of HA’s incurring large termination / restructure costs or potentially dealing with loan fund managers may prove to be more nuanced than that legal position.

Social housing operators faced with terminating the inflation-linked hedges at significant cost may have to delay development and may move into deficit as a consequence of paying the breakage cost.  If the enforced change was not made, the interest cost would continue to be serviced. It is the acceleration of this interest cost via the breakage that causes the problem.

If the inflation linked hedge is converted to an interest linked hedge, with the restructured rate inclusive of the breakage cost, the social housing operator may have to reflect this transaction in their financial statements.  The termination of the inflation hedge (recognising the full breakage cost) and implementation of a new fixed rate loan (at an off-market rate) may have to be recognised in the accounts depending on the advice from their Audit firm.

As things stand, the borrowers and the bank are at an impasse.  


It took a sustained volume of complaints from borrowers to the regulator from 2010-2012 until the FSA (now FCA) announced their initial pilot review into the sale of Interest Rate Hedging Products (IRHPs) to the SME sector in June 2012.  This resulted in a major review into the conduct of UK banks selling IRHPs to borrowers costing the banks £2.2b, including £500m in consequential losses (this excludes any monies paid out in litigation cases, or cases which were settled in mediation).

Another example of collective effort and weight of complaints was the decision by Barclays Bank in 2016 to unwind the LOBO contracts (at a significant cost to the bank) and replace the hedging with suitable, vanilla fixed rate contracts for the borrower.

There may be a precedent for collective action for Housing Associations’ with inflation-linked hedging to force more favourable treatment and at least a sharing of the costs with bank associated with restructure/termination.  However, with a tight timetable, this may have to be a retrospective outcome for borrowers.

Download PDF version here



A European taper-tantrum afoot?

12thJune 2018

Five years ago, global markets went into hysterics at the mere hint that the Fed might taper...

read more

US tariffs: The opening shots of a trade war?

13thMarch 2018

The tariffs were protested by virtually every major US economist, as well as significant players in the industries they were...

read more

How can we help you

Have you got a question about how you hedge your financial risks, or structure and arrange your debt?

Find out how we can help you by contacting us today.


contact us

Stay Connected

Would you like news and views on local and global financial markets?

Sign up today to receive news straight to your inbox.

At JCRA the privacy of your personal information is of utmost importance to us. You can find details in our Privacy Policy and Terms of Use.