Thursday, May 27, 2010

What is LIBOR?

What is LIBOR?

LIBOR stands for the London Inter Bank Offer Rate and is a measure of the average rate of interest at which banks can borrow money unsecured from each other in various currencies for various periods.

LIBOR is used to price a lot of financial contracts, for example a company might borrow money from a bank at LIBOR + 0.75% and according to the British Bankers Association, USD10,000,000,000,000 of loans are linked to LIBOR! Changes in LIBOR can signal changes in the money markets, for example a rise in LIBOR might be triggered by the expectation that interest rates will rise or the fear that it has gotten riskier to lend money to banks in general. LIBOR is quoted at an annualized rate, for example overnight LIBOR at 3% = 3%/365 = 0.00822%.

To calculate LIBOR, between 8 and 16 banks are asked to input the answer to the following question into a Reuters terminal (a secure information and messaging service):

At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?

It is up to the banks concerned to interpret the question (for example ‘reasonable market size’ is undefined). This question is asked and answered for 10 different currencies* over 15 different lengths of loan** to create 150 different LIBORs.

The answers are collated, the highest and lowest 25% of interest rates reported are discarded and the middle 50% taken and an arithmetic mean calculated.

*Pound Sterling, US Dollar, Japanese Yen, Swiss Franc, Canadian Dollar, Aussie Dollar, Euro, Danish Kroner, Swedish Krona and New Zealand Dollar

**1 day (aka overnight or spot/next), 1 week, 2 weeks, 1 month, 2 months, 3 months…..12 months.

Wednesday, May 26, 2010

Bank Funding - An overview

I thought I'd put this together to give any that may be interested a basic understanding of how banks fund themselves. It's a little simplistic to be honest but should give an idea of how things work. I'll try to post something on how LIBOR is calculated when I get round to it eventually.

There are 4 ways banks can fund themselves in normal times:

  1. Borrowing money unsecured from their customers
  2. Selling assets
  3. Borrowing money unsecured from other banks on the money markets (measured by LIBOR, EONIA etc)
  4. Borrowing money secured from other banks including the Central Bank

  1. Borrowing money unsecured from their customers

This is the biggest source of funds for most banks, for example for the Lloyds Banking Group, customer deposits were as of 31st December 2009 £406,741,000,000 compared to total loans of £626,969,000,000.

  1. Selling Assets

This is probably the second biggest source of funds for most banks as they sell shares and bonds to raise funds. This is also one of the reasons why the UK and other Central Banks have been engaged in ‘Quantative Easing’ (QE – the polite way of saying printing money) as it allows banks to sell assets at higher prices than the market would otherwise support. Our friends in the Lloyds Banking Group have £233,502,000,000 in debt securities in issue (at present value) and another £43,278,000,000 in shareholders’ equity (which is rather less than they paid for it in most cases but that’s another story).

  1. Borrowing money unsecured from other banks on the money markets (measured by LIBOR, EONIA etc)

Banks regularly lend and borrow money between themselves as a matter of course. The simplest way to explain the reason for this is to use an example. Imagine you are one of the big clearing banks. Today you have a net £2,000,000,000 in cheques, debit card payments and the like going out and tomorrow you have a net £2,000,000,000 coming in. Do you really want to sell £2,000,000,000 worth of assets today just to buy them back tomorrow, especially given the costs involved? As the amount of cash changing hands through the banking system as a whole must net to £0 it is far simpler and cheaper to borrow the money overnight from another bank that has a net inflow of funds.

LIBOR (the London InterBank Offer Rate) is a way of expressing an average of these rates banks are paying for funds.

  1. Borrowing money secured from other banks including the Central Bank

The main way that banks borrow money secured is using an instrument called a ‘repo’ or repurchase agreement. Under this agreement an asset, usually a highly rated Government bond is sent by Bank A to Bank B. In return, Bank B lends bank A up to 95% of the value of that bond. This is usually cheaper than borrowing money unsecured in the money markets. The Bank of England’s base rate is the rate of interest at which the Bank of England will lend money in a repo with a commercial bank.

If any one of these sources of funding becomes more expensive, banks will be pushed towards using the other sources, in turn pushing up the cost of those things. For example, if the Bank of England increases its base rate, a bank will be inclined to offer a higher rate of interest on its savings accounts to attract more funds in. In fact, that is the transmission mechanism that the Bank of England relies on when it changes base rates.