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It is hardly a secret that the London interbank offered rate (Libor) is broken. With banks around the world embroiled in regulatory investigations, Barclays having paid £290m in fines and others are set to follow suit in the coming months, the scandal surrounding the manipulation of Libor has been one of the big reputational hits to the banking industry in recent weeks.
Even more worrying is the fundamental breakdown of interbank lending, per se. Being able to trust the benchmark rate is irrelevant if banks are not prepared to lend to each other.
That was one theme evident in the small print of HSBC’s second-quarter results on Monday. By the end of June, the UK’s biggest bank said it now had $148bn of its money on deposit with central banks, as it continued its retrenchment from the interbank markets. In 2007 the number was just $8bn. HSBC is not alone in its nervousness. Big US banks have been experiencing a similar trend, exacerbated there by the fact that the bulk of mortgage assets do not stay sitting on bank balance sheets, freeing up more deposit funding for other purposes.
When those purposes are lacking, you end up doing whizz-bang things with your “excess deposits” – as JPMorgan did to its cost via its treasury management unit, the so-called Chief Investment Office – or leaving them with the likes of the Federal Reserve or the European Central Bank.
Banks in the US today have $1.6tn on deposit with the Fed, about twice what they held with the central bank two years ago and up from next to nothing in 2007.
The ECB, similarly, is holding more than €300bn of banks’ money. Compare that with a low of €12m in 2007. The ECB’s deposit balance has been artificially inflated by the €1tn infusion of money into the banking system via its December 2011 and February 2012 longer-term refinancing operations (LTRO), much of which remains unused. In the US, Fed deposits have been inflated by large-scale asset purchases.
But the fact remains that deposit-rich banks are far less happy than they used to be to lend to rivals. Why?
In part, it is a natural consequence of a still jittery market.
With uncertainties intensifying again in the eurozone, coupled with nagging doubts about China’s ability to manage a “soft landing” and Brazil’s worrying loan loss trends, it makes sense for financially strong banks to do the institutional equivalent of hiding their cash under the mattress.
Banks have also had to comply with tougher liquidity requirements. Before the crisis, it used to be a matter of banks’ individual risk appetites how much they held in cash or near-cash equivalents. Now global regulations are starting to specify minimum levels.
And then there is the vicious circle effect of the crisis. Stuart Gulliver, HSBC’s chief executive, says one reason why he is loath to lend to other banks now is because that kind of unsecured lending is far riskier than it used to be since such a large portion of banks’ assets are now “encumbered”, or pledged as collateral on other financing, such as covered bonds.
The more that banks have to rely on covered bonds, rather than unsecured borrowing, to raise funds, the more their assets become explicitly pledged to cover those borrowings. Ironically, the ECB’s LTRO operations, which also required asset backing, made the situation worse.
There is not much evidence yet of banks’ profitability suffering dramatically as a result of the lower returns that come with placing their money on deposit with low interest paying central banks.
When the ECB slashed rates to zero early this month, there was a plunge in balances deposited with it – from €809bn to €325bn from one day to the next. But Tuesday’s tally, back up slightly at €337bn, is still a colossal sum. Even as interest rates fall, banks are still being drawn to the haven of central bank coffers.
The paralysis in the market matters not only for the sake of healthy banks’ profitability, or because it could endanger the health of less well funded banks, but because the knock-on capacity of those banks to lend to the “real” economy is being hit. Defrosting the situation will not be easy. Regulatory change looks permanent. And nervousness around creditor risk will remain for as long as the economic cycle is depressed.
But the third driver – the “encumbrance” factor – could be mitigated by relaxing rules. Allowing banks to count investments in covered bonds towards their liquidity buffers would see groups like HSBC divert funds from central banks to lenders’ covered bond issues.
Patrick Jenkins is the Financial Times’ Banking Editor