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Market crisis over? Banks say yes, but behave as if not

by Jerome a Paris Thu Oct 4th, 2007 at 11:14:59 AM EST

Is the storm over?

Another potentially more pernicious problem is the state of the interbank market. In recent weeks, the cost of borrowing funds overnight has dropped in Europe and the US as central banks have flooded the money markets with funds. However, in the three-month money market, rates remain very high because banks are apparently hoarding their funds rather than lending them out.

(...)

It also has troubling implications for investors: the interbank freeze in effect suggests that banks do not believe their own rhetoric that the outlook is improving. In public, in other words, they may seem upbeat but they are not putting their money where their mouth is.

This is not a very visible phenomenon, because it's happening behind the scenes, but banks are still deeply troubled - and, in effect, no longer trust one another. That's what the gap between the "3-month sterling libor" (the rate at which banks lend to one another) and the "base rate" (the rate they can get from the BoE for their extra liquidity) shows: it remains close to 100bps (basis points - hundredth of a percent) rather than the usual 25bps.

It was absolutely rational for Northern Rock clients to take their money out when other banks would not lend to the troubled bank, and it is just as rational today to take with a huge grain of salt what banks say about moving on after the crisis has subsized. It has not. And banks know it - or at least they show it, unwittingly or not, in their lending practices.


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In the US and Australia, banks lend reserves to each other in the overnight reserves market ... and of course, since the US does not have an open discount window, it is that overnight cash rate that the US Fed targets with its open market operations.

However, in the US the three month markets tend to have wholesale borrowers, like finance companies, on the debt side of the market, rather than having banks on both sides.

So its banks on both sides of the three month markets in the Eurozone and/or Britain?


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Thu Oct 4th, 2007 at 11:34:11 AM EST
The 3 month money market is used by many players, but the LIBOR rate (for sterling - it would be the Euribor for euros, or the US LIBOR for dollars) sets the minimum price - it is the price that the best players get in the market to borrwo money for 3-months.

Commercia loans are usually provided on a rolling basis, i.e. with interests payable evey month, every quarter or every 6 months. The 3 or 6 months are the most used for all sorts of medium to long term operations. Interest rates are usually set at LIBOR + margin, and are reset at the end of each period (you can protect yourself against that variation risk by "swapping" for a fixed interest rate). Thus the banks charghes you LIBOR + margin, but it itself needs to borrow the money to lend it to you, and that costs it LIBOR (or more if it's considered a bad risk) - so it keeps only the margin as income.

LIBOR is thus the "riskless" rate used by the best banks between themselves. Weaker banks have higher costs of funding which they will need to deduct from the commercial margin.

In the current markets, LIBOR rates have increased hugely - i.e. for all banks and additionally many banks (such as US investment banks) need to pay additional "liquidity" costs to borrow above LIBOR. So, if anything, the LIBOR number currently understates the behavior of the market, and the very real difficulties of banks to refinance themselves.

Most other players deal either with banks or between themsleves, but using the same reference rate.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Thu Oct 4th, 2007 at 11:57:27 AM EST
[ Parent ]
... and additionally many banks (such as US investment banks) ...

Yes, I was using the normal US shorthand, and meant commercial banks rather than investment banks when I said "banks".

Part of the difference in the likelihood of banks being on the borrower side in wholesale money markets is likely to be the much bigger share of the financial sector by banks in many European countries ... I know that much commercial paper sold directly in US money markets would be commercial bank lending in many European countries.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Thu Oct 4th, 2007 at 12:19:42 PM EST
[ Parent ]
In addition, in Spain variable-rate mortgages are indexed against the Euribor (which is thus a household name in Spain - it used to be the Mibor). In the UK the practice seems to be to index against the base rate, which explains why  a month ago ceebs' girlfriend could have a mortgage rate below LIBOR.

We have met the enemy, and it is us — Pogo
by Migeru (migeru at eurotrib dot com) on Thu Oct 4th, 2007 at 01:42:52 PM EST
[ Parent ]
Let me get this one straight: you're saying that banks are lending to each other at 1% over the central bank base rate? Or is this another rate?
by Colman (colman at eurotrib.com) on Thu Oct 4th, 2007 at 12:44:58 PM EST
1% above the rate they get to "park" their money overnight with the BoE (this is sterling - the numbers are also pretty bad for the dollar and the euro). There's a different rate to borrow from the BoE, which is slightly higher than that one (and now just above what LIBOR is, IIRC).

and that's before taking into account the additional margin asked of a number of banks because they are deemed less trustworthy than the market.

And that's excluding the banks to whom others will simply NOT lend (I overheard a conversation in the lift a few days ago mentioning a major US investment bank - my bank's policy was simply to not lend them anything, and I expect others are doing the same).

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Thu Oct 4th, 2007 at 01:22:22 PM EST
[ Parent ]
Grief. That's not all that far off the rate they were charging big commercial projects six months ago, is it?

I've heard stories about reasonably significant  banks being unable to raise funds as well.

by Colman (colman at eurotrib.com) on Thu Oct 4th, 2007 at 01:35:10 PM EST
[ Parent ]
The thing is, the risk premium used to be .25%, so that had quadrupled to 1%.

We have met the enemy, and it is us — Pogo
by Migeru (migeru at eurotrib dot com) on Thu Oct 4th, 2007 at 01:39:31 PM EST
[ Parent ]
Banks don't trust each other because they know what their own books look like, and they don't like it. So they expect other banks' books to be equally unhealthy.

We have met the enemy, and it is us — Pogo
by Migeru (migeru at eurotrib dot com) on Thu Oct 4th, 2007 at 01:45:26 PM EST
From what it looks like the Base rate is actually following the Libor and not the other way around. I think I read some paper on this somewhere that claimed that this is the way it works.

So to put a question out there: is there lot of pressure to increase the Base rate? And what would happen if they did? (I have a hunch Cris will say nothing...)

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by A swedish kind of death on Thu Oct 4th, 2007 at 04:36:09 PM EST
I'd say the base rate follows the 3-month LIBOR and the overnight LIBOR follows the base rate.

We have met the enemy, and it is us — Pogo
by Migeru (migeru at eurotrib dot com) on Thu Oct 4th, 2007 at 04:45:16 PM EST
[ Parent ]
This is extremely interesting: is the Central Bank the tail or the dog?

The fact of the matter is that the true "cost" of credit is a Bank's operating costs, plus defaults.

Credit costs nothing to create, and the "price" levied by banks on lenders is therefore directly related to it's perception of default risk.

The Central Bank's base rate, on the other hand, is arbitrary, and Central Banks would essentially force Clearing Banks to lend at or around that rate through reserve requirements.

The toxic combination of securitisation, which enables banks to move debt off balance-sheet, and credit derivatives - which essentially "outsources" the only value they provide - that of their guarantee of the borrower's credit - has meant that Central Banks' Base rates will perforce follow Clearing Bank rates.

If they do not do this, then Central Banks risk falling into disrepute. ie the Clearing Bank tail is wagging the Central Bank dog.

But then, what use are Central Banks anyway? Hong Kong does not even have one, operating with a Monetary Authority instead.

Put them out of their misery I say - they shoot horses don't they?

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Thu Oct 4th, 2007 at 06:09:22 PM EST
[ Parent ]


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