The London interbank offered rate (Libor) is the rate at which banks lend to each other. When the rate goes up, funding costs for a wide variety of assets move in the same direction. Libor impacts pretty much all areas of the market, from traditional debt and equity markets to derivatives in swaps/futures, etc.
The financial crisis saw banks unwilling to lend to each other. If they were to be so kind, it would be for an extremely short period (overnight to less than three months) at a whopping rate. When the British people opted to secure a recession and leave the European Union, Libor rose because dollar liquidity was in short supply. Cross currency swaps spiked during the Brexit debacle, meaning swap lines that injected dollars into banks were implemented to prevent a mass liquidity crunch. To put it in perspective, at the beginning of June, cross currency swaps were roughly at $300m. When the Brexit vote occurred it spiked to $3bn. It is no wonder Mark Carney came out on the day looking anxious because he knew just how important a funding line would prove to be. But at least the UK can make its own laws now.
The Impact Of Regulation
Libor has risen of late, but not because credit conditions have tightened or the outlook has gotten materially worse. Rather the authorities are shooting themselves in the foot with yet another financial market regulation, this time by the US’ SEC. Institutional prime money funds will be allowed to impose fees on anyone wishing to make a redemption – essentially the equivalent of suffering a penalty fee for withdrawing your cash from your bank account.
They are also allowing fund markets to be suspended, much in the same way the circuit breakers stopped the Chinese stock market in 2015 after it fell more than 6% or so in one session. All in all, whether applied to retail or institutional investors, these new rules make the funds less attractive, which in turn puts pressure on fund managers to maintain liquidity by buying shorter-dated securities should a redemption run take place. Longer-dated commercial paper demand has fallen substantially and, as a result, banks have had to look to their peers for cash, creating upward pressure on the price of interbank loans, Libor.
Upside And Downside
But is this a bad thing for banks? When Libor rises, because all other loans are priced off Libor, a bank’s net interest margin will rise. If the bank doesn’t borrow in a period when Libor is sky high but built up a decent reserve base before the crunch, they should be better off. Of course, this is easier said than done because no one knows when the next crunch will be. The flipside to this is when rates rise, a person’s mortgage rises too, making it harder to pay back. As much as higher returns are a good thing in the short term, they could be offset by an increase in non-performing loans (the housing crisis in the run up to 2007 was a good example). Bank profitability will not return to normal from Libor rising but rather from the Fed continuing to normalise policies. That said, Libor is a rate that directly impacts real people who are on floating rate mortgages, as opposed to Fed funds or the base rate here in the UK.
A spike in Libor also impacts the closed end fund market, where some borrow from banks in order to boost returns. By no means do all borrow a lot and/or priced off Libor, but it is one to keep an eye on if credit conditions continue to tighten.