Barbican Consulting Limited
Money Markets
Money Markets
Pre and post 2007
Maturity transformation
Regulatory response
Real money
Loans, deposits, CDs, CP, T-bills, reserve accounts
How markets changed
Background
Banks have traditionally been involved in the business of maturity transformation. That is borrowing short term money and lending it out for longer periods. This is helps meet the individual needs of both depositors and borrowers. It is also good business for banks. The short term cost of money is normally lower than that of long term financing. A bank should therefore pick-up the difference between the two. This is not risk free. There is always the potential for short term depositors to want their money back leading to an inability for a bank to refinance itself. This indeed happened to many banks during the 2007 crisis. It is tempting to think that the solution is to make sure that the maturity of deposits matches that of assets. However match funding like this would be hugely expensive.
In the run up to 2007 banks sought to increase their profitability by growing both their balance sheet and margins. This meant that the absolute amount of risk being run at individual banks was also increasing. We refer to this as leverage. Whilst many blame the banks for the crisis they were not the only culprits. Central banks keeping interest rates low, politicians wanting ongoing growth and tax revenues, regulators failing to get to grips with risk and individual consumers looking to borrow all played their part.
Then in 2007 a series of events unfolded. Probably sparked by fears in the US market about mortgage lending, the extent to which banks had lent and the question about what structured debt really contained led to a sharp change in sentiment. Depositors wanted safety and pulled money out of banks. A number of firms ran into serious difficulties. The defining event was the failure of the Fed to support Lehman Brothers. In this environment contagion set in and almost all western economies were affected. The certainty that counties and banks do not fail was replaced with fear. Governments were forced to step in and support commercial banks by directly lending to them in order to support liquidity. Some central banks acted faster than others. The Bank of England in particular was slow off the mark.
From late 2007 questions were asked. How did we get in such a mess? And how do we stop it happening again? These were prompted by the growing recognition that the taxpayer had ultimately bailed out the banking system. The crisis also damaged the real economy. Asset prices fell, growth stalled, government debt ballooned, unemployment rose and living standards fell. “Light touch” regulation was no more.
The main regulatory response was to reassess risk in the banking system. The amount of capital would increase. The quality of capital would improve. Banks would hold more liquidity. Risk reporting would be intensive. Governance would be challenged. Proprietary trading would be restricted. Savers’ money would be isolated from risky activities. Data reporting to regulators would be mandatory and granular. Boards would be accountable. Failed banks would go into resolution. Shareholders and unsecured creditors would pay for future failure.
As you may expect these provisions can lead to unintended consequences and often need refinement. The cost of regulation almost guarantees that banks will not be as profitable in the future. The banking industry therefore lobbies hard to dilute the impact.
To back up the rules the authorities are taking a much tougher stance on levying fines. This includes penalties for market manipulation, weak controls, failed reporting and mis selling. The cost of these “deductions” and the associated legal bills now impact on earnings. The question remains whether they are one off or recurring charges.
Whether bank shares will prove to be good future investments is a moot point.
How has all of this affected the money markets?
Real Money
The money markets are all about real money. That’s cash and the sums involved are large – normally in excess of $5m per trade. The maturity of these deposits range from overnight to one year. The main participants are banks and financial institutions. The interest paid on deposits is referred to as the London Interbank Offered Rate (LIBOR). It varies in accordance with supply and demand conditions. Short term interest rates are usually (but not always) lower than long term rates. A yield curve can be constructed by plotting the time on the x-axis and rate on the y-axis. These rates are not static they continually move reflecting market conditions.
Libor is a controversial rate and it its construction and possibly designation will change. The controversy arises from its calculation. Banks posted individual interest rates at which they thought they could borrow money for different maturities. From these posted rates an arithmetic average was calculated and this was released at 11am London time as the day’s Libor for a given maturity.
It has transpired that during the crises banks reported rates lower than their borrowing costs in an attempt to indicate to the market that they were financially sound. It has also become apparent that banks posted rates slightly higher or lower than expected in order to benefit from rate settings on connected products like swaps. Heavy regulatory fines have resulted.
Several additional products offer depositors an alternative to the interbank market. They take the form of negotiable instruments. Unlike bank deposits they have the advantage that they can be traded and confer on the owner the ability to obtain cash before the maturity date albeit a ready buyer must be found. These products collectively are certificates of deposit (CDs) and commercial paper (CP).
For depositors who above all else want safety three more alternatives are available. They are Treasury bills (short term government debt), deposits with the central bank (reserve accounts) and deposits against collateral (repurchase agreements). As you may expect because t-bills and reserve accounts are much safer the interest rates received are minimal, indeed they can be negative.
How markets have changed
In 2007 the interbank loan and deposit market was in full flow. Banks deposited with each other without asking many questions. This changed. As soon as the crisis hit, banks became very reluctant to lend to each other. Most firms reduced their counterparty list from twenty or thirty names to just a few deemed “too big to fail”. The banking system became starved of liquidity as money pooled in a few banks and safe assets. This failure of the interbank market to recycle money has not really altered. Firms are reluctant to lend to each other without taking additional security. A situation exacerbated by the fear that in the future senior unsecured debt holders will lose part or all of their deposit should a counterparty fail. It is also true that regulators are in no rush to see the re-emergence of the interbank deposit market because of its earlier role in adding to systemic risk.
First Published by Barbican Consulting Limited, 2014