20 July 2018

Surging Libor, Once A Red Flag, Is Now A Cash Machine For Banks

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A surge in one key short-term interest rate 10 years ago was a harbinger of a crisis that nearly broke the U.S. banking system. A similar jump this year will probably add billions to the industry’s bottom line.  

The largest U.S. lenders could each make at least $1 billion in additional pretax profit in 2018 from a jump in the London interbank offered rate for dollars, based on data disclosed by the companies. That’s because customers who take out loans are forced to pay more as Libor rises while the banks’ own cost of credit has mostly held steady.

Potential pre-tax benefit is based on additional interest that could be earned with higher Libor on variable-rate loan totals disclosed by the companies. The ratio in the last column is based on the firm's pretax income for 2017.

“During the 2008 crisis, it was the sign capital markets were frozen,” said Fred Cannon, head of research at Keefe, Bruyette & Woods. “Now there’s all this liquidity, so they don’t need to borrow in the Eurodollar market,” where rates are based on Libor, he said.

Since banks aren’t dependent on the short-term overseas markets the way they were 10 years ago, they’re funding much of their operations through deposits. The companies pay those customers interest rates that stayed low even after the Federal Reserve raised its benchmark rate three times in 2017, for a total of 0.75 percentage point. The average rate paid by the largest U.S. banks on their deposits climbed only about 0.1 percentage point last year, according to company filings.

Still, some of the benefit could be eroded by higher rates the banks will end up paying on long-term debt that’s hedged using Libor-based swaps. The firms don’t disclose how much of their debt is hedged.

Most banks don’t reveal how much of their lending is at variable rates, or if they do, how much of it is indexed to Libor. JPMorgan Chase & Co., the biggest U.S. bank, said in its 2017 annual report that $122 billion of wholesale loans were at variable rates. Assuming those were all indexed to Libor, the 1.19 percentage-point increase in the rate in the past year would mean $1.45 billion in additional income.

Citigroup Inc.’s $149 billion of floating-rate consumer-mortgage and corporate loans as of the end of last year could be counted on for as much as $1.77 billion in additional pretax profit, based on the same assumption.

And Wells Fargo & Co. said in its annual report that it had stopped hedging the interest rate on $86 billion of Libor-based commercial loans to benefit from rising rates. A pile that large would generate $1.02 billion this year, not counting any other loans indexed to the benchmark that were never hedged.

Spokesmen for the three banks declined to give more details on their loan portfolios beyond what’s already in public filings.

Libor’s jump contrasts with a slow rise in other short-term rates. The U.S. tax overhaul is responsible for some of the divergence, because it eliminated U.S. companies’ incentive to keep their dollars offshore to avoid taxes. Bringing cash back home dries up the supply of dollars for short-term lending in the Eurodollar market, pushing Libor up faster than other rates.

A similar but smaller spike took place in 2016, when U.S. money-market reforms took effect that shifted money from prime funds, which lend to banks, to government funds, which invest in Treasuries. But that was short-lived because the growing pile of overseas deposits from U.S. companies eased the funding shortage, according to Phil Suttle, a former World Bank economist.

“When funding conditions change, there’s a shuffling of funding sources,” said Suttle, who now runs his own research firm, Suttle Economics. “This time around the effect might be more persistent, though, because the repatriation of corporations’ cash will be a drawn-out process, and meanwhile the U.S. government is running much bigger deficits, competing with the banks for the dollars.”

European and Japanese banks that still rely heavily on Eurodollar markets will have to grapple with higher borrowing costs due to the Libor surge, Suttle said.

Central banks in those regions have pumped trillions of dollars of liquidity into the system in recent years, which reduces banks’ need to borrow in the interbank market, according to KBW’s Cannon. If Libor stays high and the central banks start pulling cash out of the system, banks would be forced to increase borrowing in the more expensive Eurodollar market, Cannon said.

Click here for the original article from Bloomberg.  

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