Wholesale Loans & Deposits

Wholesale Loans and Deposits

If you borrow or save money at your local bank I expect the sums involved are normally small but when banks deal with each other the amounts are much larger. This market between banks for borrowing and lending cash is known as the interbank or money market. It allows banks with shortfalls to borrow and those with surpluses to lend. Imbalances like this occur everyday and every major currency has its own interbank market. It’s at the core of the world’s financial system and any disruption to it is potentially disastrous. Let’s find out a little more.

For a trade to take place two dealers must agree a value date (start date), the amount and currency, the interest rate and the maturity date. This means that the agreed interest rate is the market price for money, it is where demand meets supply.

Simple interest

For these markets interest is calculated on a simple basis. This is sometimes referred to as a money market basis. Here is an example for a short term deposit:

Amount (USD) : 5,000,000

Rate: 3.00%

Maturity: 7 days

So how is the interest calculated?

It is $5,000,000 x 3.00% x 7/360 = $2,916.66

So on the maturity date the amount repaid is $5,002,916.66

But some currencies like Sterling use a different day count basis. They use a 365 day year. If this deposit had been in GBP then the interest calculation would be:

£5,000,000 x 3.00% x 7/365 = $2,876.71

You can appreciate that getting these calculations right is important otherwise when the two banks come to settle the trade they will dispute the amounts involved.

Maturity and interest rate

Interbank loans and deposits typically have maturity dates between one day (sometimes referred to overnight money) and one year. You can do deals for longer but most deals are short term. Supply and demand conditions vary so it is usual to see different interest rates applying to different maturities. 1 week, 1 month or 6 months interest rates are therefore likely to differ. If you plot the interest rates on a graph (maturity on the x- axis and rate on the y –axis) you will see the relationship. Dealers refer to this as the yield curve (a line of best fit between the points). Yield curves move in accordance with supply and demand. These movements on a minute by minute basis are normally small but over a period of days and weeks the yield curve can alter shape significantly.

How do dealers make money?

Dealers make money by applying a dealing “spread”. This is a difference between the rate at which they borrow and lend money.

The rate at which a dealer borrows money is known as the bid rate for cash. The rate at which the dealer lends money is known as the offered rate for cash. Here is an example:

Bid 3.00% - Offer 3.10%

$5,000,000, 7 day deposit:

Interest received $3,013.88

Interest paid $2,916.66

Profit $97.22

What increases the amount the dealer makes?

Three things:

Increasing the size of the deal
Increasing the length of the deal
Increasing the difference between bid and offer rates

Libor

The rate at which banks lend cash to each other is called the London Interbank Offered Rate (Libor). The rate at which cash is borrowed or bid for is called the London Interbank Bid Rate (Libid).

Every day the Libor rate for different maturities is officially calculated (using a panel of quoting banks). This means there are different daily Libor “fixings” for 1 month, 2 months, 3 months etc. and tomorrow’s rates will not necessarily be the same as today.

These Libor fixings are very important. Not only do they tell you where banks lend and borrow money, they are also used for calculating interest payments on derivative transactions like swaps (in many cases the variable interest rate is linked to 3 or 6 month Libor). Libor rates are also used by risk managers to calculate discount factors and hence mark-to-market values.

Credit Risk

If you deposit money with a bank the main risk you have is credit risk. Will you get timely repayment of principal and interest on the maturity date? Although the probability default is small the cost to the depositor is potentially large.

This is why banks make credit assessments on each other. Bank dealers have credit limits on counterparties and can only lend when there is sufficient counterparty credit limit available.

For any counterparty dealing with a bank a proper assessment of the creditworthiness of the bank should be undertaken before transactions are agreed.

When a bank’s individual credit risk deteriorates its ability to borrow through the interbank market also declines. Such a deterioration can lead to the following.

The cost of borrowing through the interbank market can rise beyond Libor (the bank in question pays more to borrow than its competitors).
The ability of the bank to raise longer dated interbank deposits is adversely affected.
In severe situations the bank is unable to access the market at virtually any price. Under this situation the bank will be forced seek assistance from the central bank.

Interest Rate Risk

Interbank borrowing and lending can give rise to interest rate risk. Here is a short example. A bank may have made a one year loan at a fixed rate of interest and decides to finance this by borrowing every three months at a variable rate, (Libor). Every three months the bank will need to go the interbank market and refinance at the prevailing Libor rate. If Libor goes up the interest margin between loan and deposit will shrink, if Libor goes down it will widen. Mismatching the interest rate repricing has created an interest rate risk.

Liquidity Risk

In the previous example the bank lent for one year and borrowed for three months. It assumed that in three months time it would be able to refinance the loan. What happens if it cannot? A serious problem! Prior to 2007 most banks and regulators considered this liquidity risk as minimal. However post 2007 credit concerns between banks severely interrupted interbank markets. Many banks failing to be able to borrow from the markets required substantial borrowing from the lender of last resort – the central bank.

First Published by Barbican Consulting Limited 2009