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How banks ceded control of term deposits Back  
After years of successful trading, the London Inter-Bank Offered Rate (Libor) has seen dramatic increases since the beginning of the credit and liquidity crisis. John Coffey outlines the market’s dependence on this rate and explains what more could be done to remedy the situation.
Banks have lost their grip on short term liquidity since the end of the 1980s:

• Liquidity dis-intermediation: After German reunification, short-term interest rates in Europe were kept high for an extensive period of time. Money Market Mutual Funds (SICAVs Mon?taire) took advantage of this by offering a cash management tool to their investors. Medium term liquidity (three month and above) left the banking system. Today, SICAVs are the biggest investors in certificates of deposit (CDs) and commercial paper (CPs) in Europe.
• Capital requirement: The implementation of Capital Adequacy requirements in Europe made inter-bank lending activity more costly for commercial banks because the cost of capital was higher than the 12.5 basis points bid/offer spread.
• Liquidity management: Changes in regulations pushed banks to enhance their liquidity management and comply with mandatory liquidity ratios.
Consequently, banks naturally reduced their unsecured lending activity and the inter-bank money market volume shrank during the 1990s, trading shorter and shorter average maturities. Today, the inter-bank market works under a new framework whereby:
• Unsecured counterparty risk limits between banks are widely limited to one month term
• Banks raise long-term liquidity by issuing CDs
• The development of capital market/equity market activities weakened the commercial banks’ liquidity position even further.
Today most banks are net borrowers.
John Coffey

The Libor Fixing
Originally, London Inter-Bank Offered Rates (Libor) were the rates at which prime banks could not refuse to lend unsecured money to another prime bank. Libor rates are now indicative. Libor represents the rates at which AA banks could lend money to each other.

As most unsecured liquidity trades within one month, Libor rates beyond one month are almost virtual rates.

Libor rates as a global funding benchmark
Over time, Libor rates became the global benchmark for most lending activity. $5 trillion of debt is now indexed to Libor. Back-up liquidity lines offered by banks (Corporates, specialised investment vehicles [SIVs], asset-backed commercial paper [ABCP] programmes) are also indexed to Libor. However, the most staggering development has been on the derivatives side. The Bank for International Settlements (BIS) estimates that over $300 trillion of derivatives were indexed to Libor in Q4 , 2006.

Almost every asset is priced back to Libor – regardless of its original form. When a corporate treasurer issues a bond, he/she can swap it against Libor to avoid interest rate risk. Long-term fixed rate debts are then converted synthetically into Libor Floating. Some sovereign treasuries use swaps to fine tune the duration of their debt.

According to the BIS, the euro interest rate swap market grew from $584 billion in June 1999 to $2,305 billion at the end of 2006. The steepness of the curve combined with low levels of rates favoured short-term rate paying interest along with long-term fixed rate receiving interest. This illustrates the importance of Libor. Disruptions to normal pricing mechanisms can, therefore, impact borrowing costs for many businesses and consumers even if the key Central Bank lending rates are unchanged. As Libor rates have risen, the cost of funding positions has risen. Although the absolute level of three month Libor is slightly lower than pre-crisis, by around 30 basis points. Long-term conforming mortgages are still higher than levels earlier this year and non-conforming rates are still higher than pre-crisis.

What happened to the Libor rates?
In early August, traditional money market investors stopped buying term CD/CP issued by SIVs, conduits and even banks. Not only were these investors concerned about the quality of the CD/CP but they faced some losses which led to large withdrawals on concerns that these funds were invested in sub-prime or ALT-A mortgages. Many dynamic money market funds lost up to 50 per cent of their outstanding balances.

The amount outstanding in US ABCP declined for 10 consecutive weeks to a $888 billion low (from $1.17 trillion at the end of July). The size of euro-zone ABCP market has declined from $297 billion at the end of July to $192 billion at the end of September (a drop of 35 per cent compared with 24 per cent in the US).

Conduits and SIVs who had issued the CP/CDs and could not roll maturing positions drew on their back-up liquidity lines from commercial banks. The banks that had vacated the unsecured term lending market are now requiring higher rates to cope with the larger liquidity demand.

Hence, on the interbank market, term liquidity in the unsecured market richened and the process of dis-intermediation went into reverse.

The best way to assess the liquidity premium is to compare the Libor with the three month Overnight Index Swap (OIS). An OIS is an Over-The-Counter (OTC) transaction where two parties agree to exchange a fixed rate versus the compounded daily average of the Fed Funds Effective over the period.

The consecutive Fed Action ‘eased’ spreads, but the forward market is expecting the situation to take time to normalise and will eventually reset at higher level (around 20 basis points from 8 basis points pre-crisis).

(1) The ‘bid/offer’ effect
All Libor contributors are AA rated. However starting early August, the unsecured money market started to tier prime banks regardless of their rating. Some contributing banks had more need for cash than others, posting higher Libor rates. The large liquidity imbalance in the market led to a larger dispersion of rates that pushed the fixing higher.

(2) The credit/solvency effect Overall credit fundamentals for European banks were, and still are, strong (good asset quality, strong earnings, solid capital), even though they had peaked.
However, we could continue to see negative headlines in the sector, as more banks come clean in the disclosure of their exposures or write-downs. Investors will not give banks the benefit of the doubt on the extent of their losses and confidence will not be restored until after the financial year results are out in February 2008. The Northern Rock bailout threatened the UK banking sector, and we cannot exclude the possibility of another small European bank running into similar liquidity difficulties.

Banks are affected by the credit crisis via :
• Mark-to-market of on-balance sheet exposures: assets particularly subprime/Alt-A direct or indirect (collateralised debt obligation
[CDO]) exposure, structured credit & leveraged loans
• Liquidity lines given to conduits or corporates being drawn, potentially placing the bank in difficulty
• Reduced future earnings from lending, structuring, trading and investment banking
• Liquidity squeeze - The CP, asset backed securities (ABS) and inter-bank markets are more or less shut, and it remains expensive to fund longer-term, especially in subordinated paper
• SIVs breaching valuation triggers and having to liquidate investments, including bank lower tier 2 (LT2) debt, impacting secondary spreads
• Hedge fund redemptions forcing asset sales, putting more pressure on secondary spreads
• Risk of contagion to prime mortgage markets
• Risk of contagion to the real economy as banks lend less or at more punitive rates
• Large diversified banks can absorb losses and reduced earnings. Smaller banks are more at risk. So far, the only ‘horror’ stories have been from small/midsize banks such as IKB, LB Sachsen, NIBC and Northern Rock
• Banks with large capital market activities will see their earnings hurt in terms of trading, mark-to-market on investments, and investment banking than more traditional lenders.

Leverage Loan Commitments
There was $350 billion of pending leveraged buyout (LBO) deals and $130 billion of completed deals (where financing may or may not have yet been fully syndicated). Leverage loans that would have been sold onto investors are now likely to stay on the banks’ balance sheets for longer and have to be marked-to-market, impacting earnings; they may also stretch the banks’ liquidity.

ABCP conduits and SIVs
Most subprime exposure is indirect, i.e. through ABS or CDOs, with European banks having little direct exposure. Typically, ABS or CDO tranches held are highly rated, although some of these ratings have recently suffered downgrades and may see further to come.

The more important impact of US sub-prime for banks is the indirect impact through ABCP conduits or SIVs. As risk-aversion peaked and confidence vanished, the ABCP market shut, forcing some ABCP programmes to either sell assets and/or draw on their liquidity lines with banks. Back-up liquidity lines were provided by highly-rated banks (usually the sponsor bank) in order for the conduit to have high short-term ratings – necessary given the reliance on short-term funding, although the banks never expected these lines to ever be drawn.

If ABCP conduits need to draw on their liquidity lines, banks will be forced to bring these commitments on-balance sheet and provide the funds out of internal resources or through debt issuance. This illustrates why IKB and LB Sachsen needed to be bailed out, with liquidity lines representing an exceptionally high proportion of their Tier 1 capital. The smaller banks are more vulnerable to this issue than large diversified ones.

Press reports are that the Master Liquidity Enhancement Conduit (M-LEC) would buy SIVs’ most liquid and higher quality assets. The fact such a solution is being prepared shows the importance of the SIVs and fire sale issues preventing a firesale of assets at distressed levels may minimise mark-to-market losses. While it is often said that banks would have a reputational incentive to support SIVs they sponsor, we believe it will be on a case-by-case basis.

What more could be done?
• SIVs and Conduits are in a critical situation. As it remains difficult, not to say impossible, for them to sell CP, they remain exposed to a fire sale of assets. A worst case scenario could develop with further liquidation of assets leading to further deterioration of credit and further losses in funds
• The principle of the M-LEC seems good but in practice it will depend on the details and especially, the price at which M-LEC will acquire assets and its ability to attract other banks and at the end of the day investors
• More transparency and better valuation in structured credit markets is needed to restore confidence.

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