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p. 3 of 8 BACK | NEXT I. Introduction II. Borrower's Demand for New Loan Products III. Proposed New Libor-Based Loan Products IV. Withdrawal and Conversion of Pool-Based Loans V. Funding Risk Management Strategy VI. Implementation and Resource Requirements VII. Conclusion and Recommendations Appendixes

Review of Asian Development Bank's Financial Loan Products

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III. Proposed New Libor-Based Loan Products

9. In light of the borrowers’ demand for new loan products and the need for ADB to be an effective intermediary, Management judges that ADB must be able to meet the needs and expectations of borrowers through a more relevant menu of ADB loan products. A new menu should be formulated in the context of the present trend in external debt management techniques and should deliver a quality of service compatible with the “best practices” in the market.

10. The most efficient way for ADB to meet the needs of borrowers is to evolve into a LIBOR-based lender because the derivatives market is essentially LIBOR-based. This chapter will discuss the technical features of the proposed new LBL product. It is standard market practice to use the term “LIBOR” for the purpose of pricing floating-rate loans. Thus, the use of LIBOR throughout this paper is not confined to a specific currency, but rather is intended to represent a common reference interest rate for pricing LBL loans.

11. This new product will be available to both public and private sector borrowers. It is therefore proposed that the existing MBL window, which is a LIBOR-based window and basically the window for private sector borrowers, be withdrawn from ADB’s menu of loan products for new loans and replaced by the proposed LBL. The existing MBLs will however continue to be governed by their loan agreements. In other words, the features of the proposed LBL will not be applied retroactively to private sector and financial intermediary borrowers. Within the LBL window, some of the terms and conditions applicable to private sector loans could differ from those for the public sector loans. The differences will be noted wherever necessary.

A. Main Product Design Criteria

12. The new loan product proposal should have market-based features in order to provide a transparent basis for borrowers to compare the terms of ADB products with those of other lenders and to be amendable to efficient intermediation by ADB on the finest possible terms.² In defining and structuring the range of LBL products, Management has been guided by two principles: flexibility for the borrowers and low intermediation risk for ADB.

13. Flexibility for Borrowers. A high degree of flexibility should be given to borrowers from the outset (i) in the choice of currency, interest rate basis, and amortization structure; and (ii) to change the original terms any time during the life of their loans. Such flexibility is desirable for the borrowers in order to provide loan structures that can match as closely as possible the needs and risk exposures of a project as well as their external debt portfolio. Such flexibility is needed at the outset and at any time during the life of the loan.

14. Low Risk Intermediation by ADB. In developing a menu of loan products, ADB has always been guided by the principle of avoiding currency and interest rate risk exposures.³ The financial risks and the costs associated with borrowers’ choices in the terms of an LBL should not affect other borrowers’ or ADB’s income positions. Further, ADB’s traditional cost “passthrough” pricing should be maintained so that ADB can earn its basic lending spread and nothing more under all circumstances.

B. Choices Available for the Original LIBOR-based Loan Terms

15. When choosing the financial terms of a loan at the outset, it is prudent debt management practice for the borrower to structure the loan rofile to match the needs and risk exposures of the project and the borrower’s overall external debt portfolio. Consideration of the following terms, and the associated risks, is important: the currency of the loan, the interest rate basis, the loan repayment terms, and other loan charges. This section discusses the choices that will be made available to the borrower at the outset and the standard terms and conditions of LBL. Appendix 2 summarizes these terms and conditions.

16. Under the proposed LBL window, the currency selected by the borrower will be the currency of denomination of the loans (the loan currency). The loan currency is the currency to be disbursed by ADB and to be paid by the borrower for its debt service payments.

17. The choice of loan currencies offered under the LBL products reflects the borrowers’ demand for such currencies and ADB’s ability to secure the required funding in those currencies in volume and on a cost-efficient basis. On this basis, and taking into account the currencies preferred by borrowers as indicated in the survey, ADB will initially offer the LBL products in three major loan currencies: the euro, US dollar, and yen.

18. The loan agreement and loan regulations will provide a currency substitution clause that will allow ADB legally to substitute temporarily another currency for the loan currency selected by the borrower in the unlikely event of an extraordinary situation under which ADB is unable to provide the loan currency at any time for funding the loan. At the time the funding shortfall arises, ADB will work out the principles and mechanics of the substitution and normalization process, which will be designed to reflect the financial market conditions and the nature of the funding problem then. Thus, the loan regulations would clearly state that the substitution process will be done in accordance with the principles to be reasonably established by ADB.⁴

19. ADB will invoke this provision only in the event of an access constraint and after exhausting all reasonable measures to optimize the availability of the scarce currency from all available internal resources. To further protect against this risk, ADB will negotiate to obtain “evergreen” (i.e., permanent) consents from members whose currencies are of major interest for LBL lending. Such consents will enable ADB to borrow (and swap) the currencies in which it has made loan commitments, so long as the loans are outstanding.

20. ADB will offer flexibility in the choice of interest rate. Loans can be made on a floatingrate basis or on a fixed-rate basis. Because the rate fixing in fixed-rate loans is proposed to be done either on specified regular time intervals or when disbursements reach a threshold amount, fixed-rate loans will initially have a floating lending rate prior to rate fixing. Thus, the LBL product has been designed essentially as a floating-rate loan with rate fixing treated as a “conversion option.”

21. In a floating-rate loan, the lending rate will change every six months on each interest payment date, referred to also as the lending rate reset date. The lending rate will be equal to the level of the cost base rate plus a spread, which will be fixed in the loan agreement (herewith referred to as the fixed spread). The semiannual interest payment dates or lending rate reset dates of LBLs would be standardized on the 1^st or the 15^th of any month, and six months thereafter.

22. Cost Base Rate. To promote the borrowers’ capacities to use hedging instruments to manage their financial risks, the cost base rate will be LIBOR, which is the standard reference interest rate used in the market for pricing floating rate loans. In practice, the cost base rate for US dollar and yen LBLs will be the six-month LIBOR for US dollar and yen, respectively, and the six-month euro interbank offered rate (Euribor) for euro-denominated LBLs. LIBOR is also a standard measure of ADB's funding costs in those currencies, hence facilitating the pricing of LBL products on a cost pass-through basis.

23. Fixed Spread. If the primary objective of the LBL window is to offer increased flexibility for borrowers to manage currency and interest rate risks over the life of the loans, then fixedspread pricing is an essential feature as it will allow borrowers to structure their hedging transactions in line with standard market practice. For example, all currency and interest rate swaps are virtually priced on a fixed-spread basis relative to LIBOR or other standard market interest rate references. Fixed-spread pricing will facilitate any future expansion of ADB’s financial products.

24. The spread to be fixed in the loan agreement for an LBL will depend on ADB’s official lending spread prevailing at the time of loan signing. Under existing practice, after the end of each fiscal year, ADB’s Board of Directors reviews its medium-term financial prospects and the adequacy of its net income and reserves as measures of ADB’s risk-bearing capacity. On the basis of this review, the Board determines, among other things, the adequacy of ADB’s loan charges, i.e., the front-end fee, commitment charge, and lending spread.

25. Given ADB’s income planning framework, the basic lending spread is defined as the interest rate margin that ADB must earn from “all” its loans, which, together with other loan charges, will enable ADB to cover its operational costs and to meet its net income objectives. This lending spread is used to determine the lending rate on pool-based loans, and has been referred to as the variable lending spread. Under the proposed new LBL window, the “basic lending spread” prevailing at the time of loan signing will be the spread to be fixed during the entire life of the LBL.

26. Thus, the fixed spread to be applied on new LBLs for public sector borrowers will be 60 basis points, ADB's prevailing basic lending spread. This fixed spread will apply to all loans regardless of the loan currency selected. The fixed spread for private sector loans will reflect the credit risks of the specific project and borrower, and in the past has averaged about 250 basis points.

b. Fixed-rate Loans with Specified Rate-Fixing (SRF) Schedule

27. Any time during the life of the loan, the borrower may direct ADB to implement a series of interest rate fixings according to the borrower’s specified rate-fixing schedule. The fixing schedule can either be by period, i.e., regular time intervals (e.g., semiannually, annually) or byamount, i.e., upon reaching certain levels of disbursements (e.g., every $3.0 million or $4.0 million; after disbursements exceed $5 million, $15 million, $30 million etc).

1. SRF by Period. The borrower will specify to ADB the frequency of rate fixing (e.g., semiannually, annually). The rate-fixing dates will have to coincide with interest payment dates. If fixing is set at the end of each semestral interest period, the interest rate on disbursements during an interest period will be fixed with effect from the first day of the next interest period. If fixing is set at the end of a multiple interest period (e.g., every 12 or 18 months), the interest rate on disbursements during such multiple interest periods will be fixed with effect from the first day of the interest period next following the end of such multiple interest periods. From an accounting perspective, an LBL with SRF by period will be divided in tranches of disbursed amounts, with each tranche having its applicable fixed-rate.
2. SRF by Amount. The borrower will specify to ADB a “threshold” amount for disbursed amounts subject to rate fixing. The interest rate on future disbursements will be fixed when disbursements reach the specified threshold volume. The interest rate will take effect from the interest payment date after the date the threshold is reached. SRF by amount is subject to a maximum threshold volume of $500 million and a minimum volume of the higher of $3.0 million or 10 percent of the loan amount. Exceptions might be considered on a case-by-case basis.

28. The schedule of rate fixing chosen by the borrower does not have to be stated in the loan agreement. The borrower may submit a request for SRF any time, even after the loan has been finally negotiated and signed, and has become effective. Any request for SRF may be withdrawn by the borrower any time.

29. Before the interest rate is fixed, the applicable interest rate of the disbursement tranche (para. 27) will be based on six-month LIBOR tenor. All LBLs will initially have LIBOR rates.

30. The fixed interest rate on the disbursement tranche will have two components: a base rate and the prevailing fixed spread of 60 basis points. The base rate will be market-determined with value applied on the loan’s rate-fixing date. The base rate will be equivalent to the swap rate of six-month LIBOR in the currency with value applied on the rate-fixing date that corresponds to the maturities of the disbursed amount.⁵ This represents the cost of the market transaction undertaken by ADB to fund the fixed-rate disbursement tranche.

31. In general, ADB will fund the “disbursed amount” by converting (through swaps) a commensurate portion of its floating-rate liabilities into a fixed-rate liability that hedges the repayment pattern of the loan, thereby locking in the lending spread over the life of the disbursement tranche. The maturities of the disbursement tranche will depend on the available maturities in the swap market and may be shorter than the maturities agreed in the loan agreement. In such cases, the interest rate basis of a disbursed tranche will automatically revert to the floating rate at the end of the life of the fixed-rate loan.

32. A borrower may also acquire fixed-rate loans through the embedded interest rate conversion option. The option may be selected at any time during the life of a loan. Technically speaking, and from ADB’s viewpoint, the rate-fixing procedures and interest rate conversions are the same. Interest rate conversions are discussed in paras. 61-67.

3. Repayment Terms

33. The three key repayment parameters are the grace period, final maturity, and amortization structure during the repayment period, i.e., maturity less grace period. For public sector LBLs, the repayment terms will be the same as the standard terms currently available for pool-based loans. Private sector LBLs will maintain flexible repayment schedules to suit each project’s financing requirements, cash flow projections, and credit situation.

34. ADB will, however, offer two types of repayment schedules for public sector borrowers: (i) repayments fixed at loan signing, which will be standard for all loans; or (ii) repayments linked to actual disbursement for financial intermediary borrowers.

a. Repayments Fixed at Loan Signing

35. Under existing practice, the semiannual repayment schedules in the loan agreement are expressed in terms of principal amount due on each installment date, and these are fixed at the time of loan signing. The semiannual schedule of repayment amounts is determined by amortizing the principal amount committed (regardless of when the amount is expected to be disbursed) on an annuity basis using a discount rate of 10 percent per annum.

36. An important technical change to the present system is necessary to allow effective hedging by both ADB and borrowers. If borrowers are given flexibility to convert parts of a loan into another currency or interest rate, the loan is effectively being divided into subloans. Before a hedge can be executed in the market by ADB or by borrowers, the corresponding repayment structure for each part of the loan being converted must be easily constructed, particularly while the loan is still being disbursed.

37. To ensure that each part of the loan being converted has the same maturity profile, each part of the loan will have to be applied pro-rata across the repayment schedule. This proportionate allocation can be achieved under the present system if the loan will eventually become fully disbursed before the start of the first principal payment, i.e., within the grace period.

38. This will not be the case in practice because many disbursements occur after the grace period. In such a case, the sum of the proportional share of each part of the loan disbursed before the end of the grace period will be less than the initial schedule of repayment amounts, as outstanding disbursed amounts at the end of the grace period will be less than the total principal amount of the loan. As the schedule of principal payment amounts will not be adjusted if the loan is not fully disbursed by the end of the grace period, this system would have the effect of requiring that a significant portion of new disbursements (beyond the grace period) are repaid immediately after they are disbursed. Thus, disbursements after the grace period would have a disproportionate share of the scheduled repayment.

39. To mitigate this effect, the schedule of loan repayments in the loan agreement will no longer be expressed in terms of principal amount. Instead, the billed principal amount will be determined as a percentage of the loan amount outstanding. Thus, the repayment schedules in the loan agreement will be expressed in terms of percentage of the total principal amount (installment share). The schedule of installment shares will, however, continue to be determined on the present annuity basis using a 10 percent discount rate.

40. If the borrower has fully withdrawn the loan by the first installment date, the installment shares will not be adjusted. Thus, the principal amount repayable on each installment date is equal to the original installment share multiplied by the total principal amount. However, if the loan has not been fully withdrawn as of the first installment date, the principal amount repayable on each installment date will consist of (i) the repayments of all withdrawals as of the first installment date or as of the end of the grace period, calculated by multiplying the original installment shares and the amount of the cumulative withdrawals; and (ii) repayments of disbursements made after the first installment date or after the end of the grace period, calculated by multiplying the amount of withdrawal by a fraction, the numerator of which will be the original installment share specified in the loan agreement for the relevant payment date and the denominator of which will be the sum of all remaining original installment shares.

41. The proposed technical change essentially means that portions of a loan disbursed before the end of the grace period will be amortized on a 10 percent per annum annuity basis for the original repayment period. Each succeeding disbursement occurring beyond the grace period will be amortized on a 10 percent annuity basis for the remaining repayment periods.

b. Repayment Linked to Actual Disbursement

42. In addition to the “repayment fixed at signing” option, financial intermediary borrowers could have an alternative option whereby repayment installments are linked to actual disbursements. This type of repayment structure is useful to financial intermediaries that want to sublend on a match-funded basis.

43. Under this option, each disbursed amount during a semester will comprise a subloan with its own specified amortization schedule. Thus, a whole loan would be a series of subloans, each with its associated amortization schedule.

44. The grace period and repayment period for each semestral disbursed amount (i.e., subloan) will be the same and fixed at the time of loan signing. Unlike the present system, where the grace period begins with the loan approval, the grace period for this type of repayment will begin only as actual disbursements take place. When actual disbursements begin, the repayment schedule will be established for that semestral disbursed amount and the borrower will be informed of the schedule. Consequently, one departure from standard terms is that the principal repayments begin and end at different points in the loan life.

45. A loan, however, will have a fixed final repayment date (i.e., a day, month, and year) specified in the loan agreement. That date will reflect the final maturity applicable to disbursements made during the last semester in which they are expected to occur as estimated at the time of loan signing. If actual disbursements on a loan are delayed so that their final repayment date (given the fixed repayment period) is extended beyond the fixed final loan repayment date, then all repayments falling due beyond that date as a result of the application of the fixed repayment period will automatically fall due on that date. This will provide an incentive for borrowers to adhere to the disbursement schedule as much as possible.

46. These repayment features will have the effect of lengthening the average loan life. Thus, the fixed grace period and fixed repayment period, which are common for each subloan, and the fixed final maturity for the loan will be structured so that the average loan life will be consistent with the average life of such loan if repayments were linked to commitment. To achieve this, the loan can only be amortized on an equal principal payment basis instead of the annuity type applicable to other loans.

47. Borrowers may prepay in part or in full the disbursed and outstanding loan balance at any time during the life of a loan, by notifying ADB in writing at least 45 days prior to the prepayment. For floating-rate loans, if prepayments take place on a date other than the interest payment dates of the loan, borrowers will be charged a prepayment premium consisting of ADB’s redeployment cost on the prepaid loan amount, as reasonably determined by ADB. The calculation of the redeployment cost will be based on the difference, if any, between the rate at which the prepaid funds could be reinvested and ADB’s funding cost for the prepaid loan during the period from the date of the prepayment to the next following interest payment date of the loan. If ADB has to terminate the corresponding swap, the borrower will be charged the unwinding cost that ADB has to pay for terminating the swap.

4. Prepayment and Cancellation

48. Borrowers may cancel all or part of the undisbursed loan balance at any time during the life of the public sector loan without a fee, subject to the same notice period.

5. Rebates and Surcharges

49. Rebates and surcharges will be standard features for all public sector LBLs but not for private sector LBLs. The main reasons for incorporating rebates and surcharges in the features of LBLs for the public sector are the need for ADB to uphold the underlying principle behind the present variable lending-spread practice and to pass on the benefit of ADB’s sub-LIBOR funding to borrowers.

50. Thus, rebates and surcharges will have two components: (i) one that is due to the need to adjust the fixed spread on account of changes in ADB’s basic lending spread; and (ii) one that is due to adjustment of the cost base, i.e., six-month LIBOR, because ADB’s actual borrowing cost could be lower or higher than the cost base.

51. ADB’s lending spread on its pool-based loans is not fixed in the loan contract. The spread can be varied to meet evolving income objectives. Any change in the lending spread is applied not only to new loans but also to the outstanding balances of all pool-based loans regardless of when they were disbursed or approved. In other words, an increase or a decreasein ADB’s net income requirements is equitably distributed to all borrowers, a policy that reflects the cooperative nature of the institution. This also ensures small changes in the basic lending spread.

52. A system of rebate and surcharge will retain the principle of equitable treatment of borrowers in ADB’s net income planning; at the same time, fixing the spread at the time of loan signing will enable the borrower to immediately access risk management instruments.

53. The new LBL product must have a market-cost base that allows efficient use of risk management products; this is the reason for selecting six-month LIBOR as the LBL’s cost base. However, ADB’s funding costs are generally lower than six-month LIBOR, a reflection of ADB’s strong credit standing. ADB’s funding cost relative to LIBOR is referred to as ADB’s funding cost margin. With the fixed spread on LBL determined solely on the basis of ADB’s basic lending spread, the question arises of how the principle of cost pass-through pricing can be reflected in LBL pricing.

54. Since rebates and surcharges are needed to make ADB’s LBL product consistent with ADB’s present income planning methodology, the fixed spread on an LBL should not be determined on the basis of ADB’s projected funding cost margin vis-à-vis six-month LIBOR. Instead, actual sub-LIBOR funding cost margin will be returned to the borrower through a rebate, and actual over-LIBOR funding cost margin spread will be recouped from the borrower through a surcharge. This will uphold the present principle of automatic cost pass-through pricing.

55. The broad mechanics of determining rebates and surcharges will work as follows. To maintain the equitable treatment of LBL borrowers, a funding pool will be earmarked for each of the three LBL currencies. The average cost margin of the pool relative to LIBOR will be calculated twice a year, i.e., 1 July and 1 January, and announced by ADB. Thus, the average cost margin calculated as of 1 July each year will represent ADB’s actual average cost margin that has prevailed during 1 January-30 June, which will be shared by all LBL borrowers regardless of when their loans were approved or disbursed. Together with the average cost margin, ADB will also announce the change in the basic lending spread. The average cost margin and the change in the basic lending spread will be applied to the loan amount for the relevant interest period, which is the same balance upon which the interest billing has been actually calculated and received. Rebates will be credited only after borrowers have made interest payments.

6. Other Loan Charges

56. The current commitment charge of 0.75 percent applied on progressive amounts of undisbursed loan balances and front-end fee of 1 percent applied to pool-based loans will continue to apply to public sector LBL products. Other loan charges for private sector loans will also remain unchanged.

C. Flexibility to Alter the Original Terms of LIBOR-based Loans

57. In contracting an ADB loan, a borrower is assuming a liability that is expected to be part of its balance sheet for a long time (up to 30 years). Even though the borrower has carefully considered the loan’s financial terms prior to negotiation, its debt management needs and risks may change over time. The borrower may thus wish to review its original selection of currency choice and interest rate structure. If the borrower chooses to do so, it can use the conversion provisions embedded in the LBL any time after loan effectiveness without entering into a swap agreement with ADB or amending the loan agreement, subject however to the relevant provisions of the new loan regulations and of the conversion guidelines.⁶

1. Changing the Currency Characteristic of the LIBOR-based Loans

58. The borrowers may change the loan currency of all or part of the undisbursed and/or disbursed loan amounts at any time during the life of the loan by requesting a currency conversion. On conversion of outstanding loan, the interest rate applicable to the converted outstanding loan can either be floating rate or fixed-rate applicable to the approved currency. The terms of the currency conversion of outstanding loan will reflect the cost of ADB’s currency hedge transaction. The interest rate applicable to the converted undisbursed balances subsequently withdrawn and outstanding will be the floating rate applicable to the approved currency, including the fixed spread stipulated in the loan agreement. The partial amount converted will be applied pro rata across all maturities of the loan.

59. In many cases, the borrower may want a currency conversion of the outstanding amount for the remaining full maturity of the amount of the loan to which the conversion will apply. However, in some cases ADB may not be able to execute a corresponding market transaction for the entire residual maturity of the loan. The nonavailability of longer dated currency swaps combined with asset and liability management considerations may constrain ADB from meeting such requests. In such cases, the currency conversion will become a partial maturity conversion.

60. In a partial maturity conversion, the currency of denomination will revert to the original loan currency (i.e., currency before a conversion) upon the expiry of the conversion period in which the amount would have been denominated without the conversion. The interest rate will also revert to the original interest rate applicable to the loan currency. The principal amount remaining at the end of the conversion period expressed in the original loan currency will not be known until the end of the conversion period, depending on the then prevailing exchange rate. The borrower therefore must assume the exchange rate risk.

2. Changing the Interest Rate Characteristic of the LBL

61. Borrowers may also change the interest rate basis of an LBL at anytime during the life of the loan by requesting an interest rate conversion to fix or unfix their interest rate, or by buying a cap or a collar, subject to relevant swap market opportunities being available to ADB.

62. Rate Conversion for Floating-Rate Loans. The borrower may request at anytime a conversion of all or part of a floating-rate loan into a fixed-rate loan denominated in the same currency or in another currency in which ADB lends. Upon conversion, the interest rate is the cost base rate as defined in paragraph 30 plus the lending spread stipulated in the loan agreement.

63. Borrowers may wish to prearrange a specified rate-fixing (SRF) schedule (para. 27). Otherwise, borrowers will be responsible for deciding when to request ADB to fix the rate on their loan. Borrowers may cancel such SRF schedules, but not once ADB has executed the trade.

64. The maximum maturity of interest rate conversion from a floating to a fixed-rate will be limited by what ADB can get from the market, currently at 10 years. Longer maturities may be possible on a case-to-case basis, depending on market availability. If ADB is not able to execute an interest rate hedge transaction in the market for the full remaining maturity of the loan or if, at the borrower’s specific request, the interest rate conversion period will be shorter than the remaining maturity of the loan, the interest rate payable on the amount of the loan to which the conversion applies will revert upon the expiry of the interest rate conversion period to the interest rate that would have been applicable to that amount in the absence of the conversion.

65. Rate Conversion for Fixed-rate Loan. The borrower may request any time for a conversion of all or part of a fixed-rate loan into a floating-rate loan denominated in the same currency or another currency in which ADB lends. Upon conversion, the interest rate is the sixmonth LIBOR for the relevant currency plus a certain spread which will consist of the lending spread stipulated in the loan agreement and unwinding costs of related hedge transactions, if any. Consistent with standard practice in the swap market, the unwinding costs would be determined on the basis of the difference between the original fixed-rate of the loan and the fixed-rate prevailing in the market at the time of the conversion.

66. Interest Rate Cap and Interest Rate Collar. If borrowers wish to mitigate their exposure to interest rate volatility, but not eliminate it altogether, they can purchase an interest cap or collar. As insurance against rising interest rates, a borrower may wish to establish an upper limit (a cap) on its floating rate. A capped loan will keep the borrower’s interest cost on a floating rate basis, while providing the insurance that the borrower’s base rate LIBOR will never exceed the cap. This means that if the floating rate exceeds the interest rate cap on any LIBOR reset date, the borrower will pay the interest rate at the cap. Such a cap has, like any insurance, a price: the premium, which is payable in advance. The premium of the cap is expressed as a percentage of the outstanding loan amount. Maturities of interest rate caps are generally limited to 10 years.

67. An interest rate collar ensures that the borrower’s floating rate payments remain within a certain band. This is usually used to reduce the premium payable on an interest rate cap. By establishing an interest rate collar, the borrower, in addition to establishing a cap on its floating rate (for which it pays a premium), also establishes a lower limit (a floor) on the same floating rate for which it receives a premium. The premium the borrower pays is settled against the premium it receives.

3. Pricing of Conversions

68. The three pricing components in a conversion transaction are: (i) market rate or cost base rates, (ii) the lending spread stipulated in the loan agreement, and (iii) transaction fees. The market rates are generally the same cost base rates used for the original term of the loan, i.e., six-months LIBOR for rate conversion from fixed to floating plus other market costs such as a premium or discount, depending on market conditions, and the swap rate equivalent for sixmonth LIBOR for rate conversion floating to fixed.

69. The transaction fees, expressed as a percentage of the principal amount involved, will reflect a reasonable amount of compensation to ADB for providing loan conversions without discouraging prudent use thereof. These fees are generally lower than the fees being charged by other multilateral development banks (MDBs). Rate fixings for up to the full amount and maturity of the loan are free of charge. This formulation is used to convey Management’s intention that borrowers have the opportunity to obtain a fixed-rate loan for the full original loan amount and maturity without a transaction fee as if fixed-rate lending is a separate facility. Since in prevailing swap market conditions ADB expects to be able to offer interest rate swaps of 10- 12 years or more for loan maturities up to 20 years, two or more interest rate swaps for each disbursed loan amount may be needed for aggregate time periods up to the full maturity of the loan. Table 1 summarizes the proposed transaction fees.

D. Enhancement of Existing LIBOR-based Loan Terms for Private Sector Borrowers

70. The main features of the proposed LBL window, which will apply to private sector borrowers, are a significant enhancement of the existing MBL features. These are discussed in the following paragraphs.

71. Interest Payment Dates. Under the existing MBL window, borrowers are only allowed to choose 15 March and 15 September or 15 June and 15 December as lending rate reset dates. Under the new LBL window, reset dates can be on the 1^st or the 15^th of each month and six months thereafter.

72. Interest Rate Fixing. The timing of the choice of interest rate basis (i.e., floating or fixed) could be critical to some private sector borrowers. Under the MBL window, borrowers are given up to the time of the first disbursement to decide whether a loan should carry a floating or fixed-rate. When a borrower selects a fixed-rate, future rate fixing will be made from the point of disbursements. Under the proposed LBL window, all loans will initially carry a floating rate but borrowers are given the utmost flexibility to decide when to request ADB to fix the rate on the loan. The rate-fixing schedule to be designed by the borrower can be done through a separate request at any time. Such request may be withdrawn by the borrower at any time.

73. Interest Rate Conversion. Under the existing MBL window, a borrower is given only one option to convert its floating rate loan into a fixed-rate loan or vice versa. The proposed LBL window will allow private sector borrowers to change the interest rate basis of their loans more than once, subject only to ADB’s ability to transact the corresponding interest rate swap in the market. Further, private sector borrowers under the new LBL window can also request for an interest rate cap or collar on their floating rates.

74. Currency Choice and Conversion. As for MBLs, LBL loans can be denominated in one of the three major loan currencies: the euro (instead of the Swiss franc in the case of MBL), US dollar, and yen. Unlike the MBL window, private sector borrowers can change the loan currency of all or any portion of the loan to another currency more than once at any time during the life of the loan.

75. Repayment Terms. Under the proposed LBL window, the repayment terms for public sector borrowers will continue to be designed as in the past, except for financial intermediary borrowers, which can request subloan tranching, i.e., repayments linked to actual disbursements. New loans for private sector borrowers will continue to be based upon project needs for grace period and final maturity. Amortization structure may be annuity or mortgage style, or tailored to meet project needs in a manner acceptable to ADB.

76. Credit Spread, Rebate, and Surcharge. Within the proposed LBL window, the essential loan pricing differences between private and public sector loans are the lending spread and the provisions on rebates and surcharges. The lending spread to be fixed over the cost base rate on all public sector borrowers is ADB’s prevailing basic lending spread, currently 60 basis points. However, since private sector loans do not carry government guarantees, the lending spread on them will differ from that on public sector loans. The lending spread applicable to private sector loans should reflect the credit risks of the specific borrower and would continue to be set in accordance with policies applicable to private sector loans. Rebates and surcharges will not be applicable to private sector borrowers.

77. Documentation. Three documents will govern the LBL products for public sector borrowers: (i) loan agreement, (ii) loan regulations applicable to LBL loans from OCR, and (iii) conversion guidelines. Private sector borrowers will have greater flexibility on applying the guidelines than will public sector borrowers, and may choose to have the standard documentation for public sector borrowers or a self-contained loan contract that will incorporate the relevant provisions of the three documents, or a combination, as appropriate.

E. Proposed Timetable

78. Management proposes that the new LBL product be made available for loans for which an invitation to negotiate is issued on or after 1 July 2001.

79. In proposing this timetable, Management has taken into account the following factors. First, borrowers have strongly requested for a timely introduction of the new products. They clearly stated through the survey that they would like ADB to respond to what IBRD is doing as soon as possible. In this light, introducing the new loan product on 1 July 2001 will enable many borrowers to quickly have access to LBL products because a large number of loans are considered for Board approval in the second half of the year.

80. Second, the implementation work associated with the introduction of the new loan products is considered manageable because of the benefits accruing from IBRD’s extensive work on their new loan products, which are similar to the proposed LBL. Both the work on loan documentation and outreach program with borrowers will thus be considerably reduced.

81. Third, the proposed LBL can be considered as an expansion of ADB’s MBL window, which is essentially a LIBOR-based window. Since the establishment of the MBL window in 1994, staff have gained valuable experience and expertise in LIBOR-based lending and the associated risk management system. Nevertheless, as in the case of IBRD, ADB will need to undertake a total redesign of its loan accounting and loan administration systems to address the specifities of the LBL product.

F. Expected Future Directions

82. The evolution of ADB into a full-fledged LIBOR-based lender will have to be done in stages to allow for the installation of interim systems and orderly development of the new loan accounting and treasury risk management systems. This also will give borrowers and ADB staff time to become familiar with the new products.

83. Looking forward, Management expects that the future work program for the evolution of ADB into a full-fledged LIBOR-based lender will include considering the

1. prospect of providing borrowers greater flexibility in choosing loan repayment terms, i.e., grace period, final maturity, and amortization structure;
2. prospect of offering free-standing hedging products, including commodity swaps;
3. prospect of expanding the currencies offered by ADB, including the feasibility of lending to borrowers in their domestic currency through local currency swaps; and
4. feasibility of reconfiguring outstanding balances of pool- based loans (emphasizing that any costs of reconfiguration will have to be passed on to the borrowers).

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