The significance of the recent moves in inter-bank markets and Libor

Recently there has been a rise in the interest rates at which commercial banks are willing to loan to each other, furthermore this rise has come with the realisation that they are not all trading at the same interest rate with banks that are perceived to be secure trading at a cheaper interest rate than those who are perceived to be not so secure. This has also been accompanied by rumours that at times some banks cannot raise finance and liquidity at all from this source, so the market has in effect closed to them. In effect the market is showing signs of dislocation. Now this may seem something to be left in the arcane world of specialists and bankers but it does have wider significance. For example back in 2008 this system was in effect flashing an amber and then a red light before Lehman Bros collapsed.

What is Libor?

Libor is the London inter-bank offered rate and is used as a benchmark for lending by banks all around the world. It has versions in different currencies for example US dollars, Euros and pounds sterling. This interest rate is used mostly in the shorter term international banking market although it can be used for loans with duration as long as five years. The role that it performs is that it allows banks who require cash and liquidity to borrow quickly (and usually easily) from other banks with surpluses and hence cash to lend. This means that banks can be more flexible because they do not have to hold large amounts of liquid assets individually as they can draw on the interbank market if say they make some large loans, so in effect it acts as a backstop for them.Libor is officially fixed once a day by a group (16) of large London banks, but the rate often also changes during the day.

So in effect Libor and the inter-bank market make banking more efficient and it helps oil the wheels of international banking. It is used as a benchmark for many interest rates around the world both in the institutional and retail market.

What has been happening to Libor?

On Monday of this week 3 month US dollar$ Libor rose above 0.5% for the first time for ten months when it closed at 0.50969%. A particular factor in this rise was the fact that the Bank of Spain had been forced to rescue the regional lender and savings bank Cajasur which led to increased anxiety in financial markets and was the subject of my article on Monday. As the week has gone on we have seen the rate rise to yesterdays closing level of 0.53844%. Just to give you an idea of the scale and speed of this month 3 month US dollar Libor was at 0.3% some 6/7 weeks ago.

There is another spread that has been moving wider in recent times too. This is the Libor-OIS spread where OIS stands for Overnight Indexed Swap. The reason why this is significant is that the OIS is considered to be the risk-free interest rate and is usually expressed as the market’s expectation of the official central bank interest rate. For example expectations of the fed funds rate are used in the United States and expectations of the base rate in the UK. Now you get to my reason for looking at it. Think of the two rates one is representing interbank trading and credit risk and the other is not. So subtracting one from the other gives a guide to perceived credit risk in the relevant currency.

This spread has widened recently and closed yesterday (27th May) at 0.3% or 30 basis points for the US dollar. In normal times a measure for this might be considered to be around 10. Back in late 2009 the spread did head back to that sort of level but as I am describing here more recently it has been moving away from it.

Another sign of the problems has been the dispersion in the quotes offered by the 16 banks. In normal times it is not impossible that they will offer the same price for Libor or only be a basis point or two apart. Last Friday showed a situation where Libor settled just blow 0.5% but the spread of rates offered went from HSBC 0.41% to West LandesBanken 0.545%.

What will happen next?

As you might imagine this rise in Libor accompanied by the rise in the Libor/OIS spread is starting to make people nervous. There are starting to be some apocalyptic forecasts with Citibank feeling that it could rise into the 1 to 1.5% range. As so far it has edged up slowly I think that it is bit premature to project such figures. But it is the dispersion between banks that bothers me the most as it is the clearest signal that they do not trust each other at this time. If I was a shareholder in the banks which have to pay more I would have some very serious questions for the banks board.

We could easily see a rise to 0.6% for US $ Libor and this is not a good trend. US dollars are in demand and this is often a sign of uncertainty.

What Libor is used for?

In the UK this rate is mostly used in institutional,commercial and professional markets although there were mortgages which particularly in the pre-credit crunch era were based on the Libor rate (and led to much pain as it rallied in 2008 and for a while did not fall much even when base rates were cut). In the United States there are Libor futures traded on the Chicago Mercantile Exchange. For individuals Libor affects a variety of loans and in particular it affects mortgages and the use of it becomes more common as the size of the mortgage increases, and it like the UK it was used before the credit crunch as a benchmark for many of the subprime loans issued during the boom. Libor’s fluctuations also determine the monthly rates on many commercial loans.

I notice that this recent spike is leading some American commentators to question the widespread use of Libor although there is a less clear answer to what one might use instead.

Commercial Paper Markets

These  markets have shown signs this week of being affected by the same factors which have influenced Libor. The Wall Street Journal pointed out on Tuesday that American commercial paper markets were showing signs of drying up.If you look at the interest rate for European commercial paper then interest rates have risen from 0.34% to 0.48% over the last 2/3 weeks so the pattern of Libor looks like it is beginning to be repeated here.

Conclusion and Comment

Firstly these issues are on nothing like the scale that was seen pre the collapse of Lehman Bros. However a counterpoint to that is if you consider the amount of extraordinary intervention and monetary stimulus applied by the worlds central banks over the last 18 months or so then it certainly should not be.

Another way of looking at this is the way that the Federal Reserve has recently reinstituted the swap lines that it had with the worlds other main central banks during the height of the credit crunch. In another form this too declares that there are problems and issues with the world’s banking system. The truth of this is that the world again wants US dollars and this is associated with a flight to quality and safety. After all the measures that the worlds central banks have brought into play this is not an inspiring result. It ia also significant in that central banks were planning to use 2010 to remove some of the crisis measures they had brought into play not reinstate them!

There are many explanations of why the Libor and associated rates have moved as they have. For example the European sovereign debt crisis and fears for what debt banks are holding. But in essence we are back to out two old friends fear and uncertainty.

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10 thoughts on “The significance of the recent moves in inter-bank markets and Libor

  1. I have question, Shaun, if I may? Can you tell me what the Commercial Paper Markets are? And in perhaps describe in more detail your sentence, “The Wall Street Journal pointed out on Tuesday that American commercial paper markets were showing signs of drying up.”. Thanks very much.

    Robert

    • Hi Robert
      Let me try and explain a litttle more. If we start with what the commercial paper is. It is an unsecured promise to pay a certain amount on a stated maturity date, issued in bearer form. So it allows companies and businesses to raise short-term funds directly from end investors and is usually done via an own in-house sales team or via an arranged placing through bank dealers.
      Now sometimes banks use it but it is more often used by companies and so I was trying to make the point that problems in a bank related market may also be spreading to one of the costs of borrowing for other companies and businesses.
      As it happend the most public example of this happening this week was for the Spanish bank BBVA which had debt of around 1 billion Euros in the US commercial paper market but decided to look elsewhere for funds.

  2. It points to the fact that still the banks are too dependant on the wholesale markets be it interbank or commercial paper for funding. There are strong rumours that a particular retail banking group (I dare not name it) has been to the Bank Of England SLS (discount window) implying that it cannot fund within the wholesale market.

    So long as the banks have such an unstable asset and capital base there will be justifiable cause for concern. The role of government has much to answer for.Take for example RBOS and LLOY’s where too much emphasis has been placed on trying to turn a profit from emergency rights issue share purchases.The quid pro quo to this was that the banks had to do less to deal with risky liquidity arrangements.

    Robert .Commercial Paper is basically short term (under 1year) unsecured lending by companies (inc banks).Many companies have a programme where they finance their balance sheet via this source. CP loans when they are due for redemption are wherever possible ‘rolled over’ with the original lender.However if lenders take fright this source of finance can quickly evaporate.

  3. Do you have a link to LIBOR quotes ? If this is, in essense, an early warning sign of trouble (as well as an interbank lending rate) it might be useful. Magnificent explination Shaun.. as always.

    • Hi Mr K
      A lot of news services are publishing the rates because of increased interest (sorry!) in them. I have tended to pick them up from the FT as I have been happy to get them a day late however Bloomberg have a quote service which for libor 3 month for the $ is US0003M:IND. The charts are interesting on it. I recommend you take a look at the 6 months version to see what has happened recently and then the 3 or 5 year which shows the impact of Lehmans etc. Looking at it like that makes the current move in pure arithmetic look like a foothill but the counterpoint to that is all the central bank action we have seen including the recent swaps deals.
      So much for withdrawing extraordinary measures….

  4. If and when banking reforms are introduced, one requirement for a prudent retail bank would surely that it does not rely on wholesale funds other than for temporary fluctuations, a change that would have profound effects on the deposit savings and consumer credit markets. Alternatively, liquidity requirements for wholesale deposits should be very much higher than for retail and normal commercial deposits, because they are more subject to runs. This would have similar effects, painful in the immediate future but ultimately more healthy.

    • Hi Graham and welcome
      As I have written in my articles on here I feel that we need reform to banking sectors worldwide and this also applies to the UK. It is disappointing that we have had so little reform in the UK. If you think about it I believe that if you look at the last 18/24 months they disprove that theory that better regulation would have stopped things. After all if that worked then governments and regulators would have introduced far-reaching reforms over this period, we are unlikely to get a period where in theory they should be more motivated! If they have not done so after what has just happened then it’s not very likely they will act in the next boom to my mind.

      As to changes I am wary of the search for a “magic bullet” and feel that we need overall reform. For example there was something in the changes suggested by Paul Volcker in the US, I also feel that shareholders need to regain more control over companies and reduce the power of the managers and directors, and that for directors one should differentiate between mistakes and negligence and that negligence should have punishments such as no longer being able to be a director in future and for the worst type jail. I think this would have helped say in the Northern Rock scenario where plainly it relied too much on wholesale markets but rather than banning use of wholesale markets I would have a wider “negligence” clause for directors.This could be applied in future when a bank leaves itself dangerously exposed but as markets are very inventive I would prefer to define around outcome rather than cause….

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