Hamish McRae: Libor fiasco will make borrowing harder
Sunday 15 July 2012
The move towards a world where people have to use their own money to buy anything rather than borrow other people's has taken another lurch forward – a world where banks have to say "no" rather than like to say "yes". The reason: the Libor debacle. It is hard at the early stage to put any numbers on the costs to the banks that will result from fines and legal actions but it is clear that it will hasten a change in the culture of the industry and also the speed at which it will shrink.
In the coming weeks we will have a string of stories about fines being levied on the big banks. Presumably these will be larger than that imposed on Barclays, which hoped that by doing a deal swiftly it would gain more lenient treatment. So we are talking fines running in the billions. In relation to the size of the industry this will be bearable – tiny compared with losses from dodgy property lending.
There are however two other elements. One will be private legal actions against the banks; the other possible criminal charges. There is not much point in speculating about the latter, except to observe that the risk/reward ratio for anyone in a senior job in banking has shifted dramatically. But were the legal course to follow that of the class action against BP over the spill in the Gulf of Mexico the numbers become very big indeed.
The Libor cloud will hang over the banks for five years or more and will have a number of effects.
For a start, the entire syndicated loan market is undermined. It is hard for us to remember a world before the money markets – before Libor was coined to describe the rates at which they lent to each other on them. For Libor dates back to the 1960s, to the early days of the Eurocurrency markets, when London-based banks hit on the idea that they might trade deposits with each other over the phone, instead of relying on their own deposit base to fund their loans. (It is the London Interbank Offered Rate.) Syndicated lending, splitting loans between a group of banks took off on an international scale when banks were confident they could go into the market and buy the deposits they needed to fund their bit of the loan.
So without the London-based deposit markets, the great expansion of the world economy would have had to be financed by securities markets instruments. Undermine confidence in the pricing of those deposit markets and the entire banking system of the past 50 years is undermined. If you don't trust Libor, you have to peg loans to something else.
You can do that. Before the present system all rates were tied to one set by the central bank, in the case of the UK it was Bank rate. Many mortgages are still tied to Bank rate's successor, base rate. That is causing losses for many banks because base rate is so low that they are losing deposits, but at a retail level there is enough stickiness to enable the system to work.
At a commercial level, money is less sticky. Large depositors shift cash around for the best rate – or rather the best rate from a panel of banks they deem safe. If big depositors take their money away from banks, putting it perhaps in government bonds, those banks cannot fund their loan book. The result is they make fewer and/or smaller loans.
The next effect of a loss of trust in Libor is a loss of trust in banking as an industry. Banks are being urged to raise more capital to protect themselves and their depositors. But they have over the past four years been a terrible investment. The left-hand graph shows how, that Japan apart, banks are worth less than half the level they were at in 2003, relative to the market as a whole. This is not a pretty prospect for investors, made worse if the bank may be sued. If banks cannot raise more capital they have to shrink their balance sheet. In other words, they have to make fewer and smaller loans.
Put this together and there are at least four ways the Libor disaster will undermine banking globally.
First, bankers will be more cautious. They will be custodians of other people's money rather than go-getters taking risks, as they will punished if the risks go wrong and not rewarded if they go right.
Second, the cost of fines and other legal actions will reduce their profits, which are needed to help build up their capital base. If banks cut dividends, or delay their return to paying them, that reduces their hope of raising new capital.
Third, their core commercial business of making loans tied to Libor has been undermined and will shrink.
And finally, aside from the direct impact on their capital-raising ability, there is an indirect impact on this from reputational damage.
So: banking becomes smaller relative to the size of the economy. We will borrow less and pay back faster. And we will do so when we are already under pressure to service our existing debts. A final twist to the story is that debt service ratios in the UK particularly have until recently still been rising, as the right hand graph shows. This is the sum of interest payments and debt repayments. We still have a long trudge ahead.
It's no game when Nestle's a sweeter bet than the whole of France
Two euro-related stories caught my eye at the weekend. One was a little news item noting that Nestlé, the world's largest food company, can borrow more cheaply than France.
According to Bloomberg the maker of KitKats and instant Nescafe coffee sold €500m of bonds due in 2019 at a yield of 1.56 per cent.
France's debt for the same duration was trading at 1.58 per cent. Moral: investors think a large corporation is more likely to repay debt on time than the second largest country in the Eurozone.
The other one was a rather naughty bit of research by Bank of America, which applied game theory to the plight of the euro and concluded that Italy would be able to leave relatively easily and, if managed properly, would gain from leaving – actually gain more than Spain or Greece.
Ireland would also gain from leaving, but not as much as Italy, according to the BoA's analysts. Germany, of course, would find it easiest to leave but would gain least from doing so.
Indeed it would suffer from Italy's increased competitiveness following a devaluation, as it did from previous devaluations of the lira currency.
Since Germany would lose from Italy leaving, could it bribe Italy to stay in? Well, it could try, but the costs would be huge given Italy's national debt, larger than Germany's, and the Italians might not be prepared to do the things Germany would demand to keep it in.
Conclusion from these two snippets? The risks of break-up are not yet priced properly into the markets but the once unthinkable is now being thought.
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