Why do Banks lend to each other ?
It is a natural feature of banking that at a given moment in time some banks have lent more money to their customers than they have received from their saving customers. An example might be a credit card bank like Egg or Capital One. Conversely other banks may have more deposits than loans such as ING Direct. The interbank money market is a mechanism that allows banks to iron out their imbalances. Essentially, the banks with surplus money sell the money to those banks that need it. (These days it is not just banks who are in these markets, hedge funds and other financial institutions along with some of the biggest corporations are major players too). There are three broad means that are used to get money from one bank to another.
- Money Market Loan and Deposits
- Syndicated Loans and Loan Markets
- Securitisation and CDO’s
Money Market Loans and Deposits
This is probably the simplest to understand. The banks just lend each other money, a bit like they lend customers money and the amount they are prepared to lend to a bank is a function of their perception of the risk of that bank not repaying the money and also the amount they have already lent to that bank. (They don’t like to build up too high a volume of lending to an individual counterparty – even a bank. This is called “Concentration Risk” of “Large Exposure Risk”). The other factor in interbank lending is the price they charge each other for the money – the interbank lending interest rate. This is called LIBOR (London Interbank Offer Rate) for sterling money; or EURIBOR for euro money. If the banks are feeling cautious about lending each other money the price (i.e. LIBOR) goes up. This is exactly what happened in the August 07 credit crunch where LIBOR jumped from values of around 4% to 6%. These interbank rates are important beyond the interbank money markets because lots of loans to (particularly corporate) customers use them as a reference (e.g. a loan to a corporate might well be quoted as LIBOR +100 basis points).
Thus, recently, when banks felt unhappy about lending to each other and hence forced the LIBOR rate up, the costs of borrowing to corporates jumped as well.
Another feature of the Interbank money markets are that the bulk of the loans and deposits are relatively short term, typically overnight, days or months in term. This is true even though many banks are using these funds to lend to customers for long periods (e.g. a mortgage of 25 years).
Based on the above diagram let us consider an example of a mortgage bank that hands over the money to the person who needs the mortgage, for example for £0.5M, it might borrow that £0.5M from the money markets for 3 months to give to the person applying for the mortgage. Three months later it has to repay the money to whoever they got it from in the markets. Clearly they can’t get the money back from the person who took out the mortgage because his contract says he does not have to repay for 15 or 20 years. Therefore the bank who lent the mortgage money has to go back to the money markets to borrow the £0.5M to repay the previous £0.5M. This could be with the first bank that lent them the £0.5M (called a rollover – the 3 months contract is effectively extended for another 3 months albeit at the new prevailing interbank rate). It could be with a different player in the interbank market.
This behaviour of borrowing “short term” to lend “long term” is inherently risky. The bank making the mortgage is vulnerable to being declared bankrupt if the interbank market dries up for them.
The good news for banks is that they are dealing with large numbers of loans and deposits and with lots of other banks so for the most part “borrowing” short and lending long is not a problem provided it is not exploited too extensively. Statistical behaviour means that there are usually some banks with some money to lend. Even if there is not, a lending bank will have enough customer deposits (e.g. customer current accounts) or loans finishing and so being repaid that the bank can make its repayments to the money market lenders.
We have previously written articles describing what are syndicated lending and Loan Markets;
So, we will not repeat that here. The relevance here is that, if a bank has a very large loan to a corporate customer it needs to “fund” that loan; i.e. borrow money from the loan market to be able to lend the money to the corporate customer. An alternative is to chop the loan into chunks and “give/sell” some of the chunks to another bank. This reduces the size of the loan that the first bank has to fund itself. This is quite a common practice, particularly where corporates need a lot of money in a hurry; e.g. to buy another company in a competitive hostile takeover situation. One bank, the lead bank, “underwrites” the whole amount to the corporate but then busily sets about transferring the bulk of or all of the loan to other banks (the lead bank is typically an investment bank and is interested only in the fees for the transaction rather than being a long-term holder of the loan).
Securitisation and CDOs
This is not the place to describe all the mechanics of Securitisation and Collateralised Debt obligation (CDOs) but they have a common aim. Essentially a large number of loans with common characteristics (e.g. mortgages, credit card loans etc.) are bundled together and sold to special Purpose Company ( sometimes called an SPV in banking jargon) which is set up with the intention of being the legal owner of these loans (i.e. the banks are no longer the lender). Simultaneously the Special Purpose Company sells shares (or bonds) in itself so that the owners/bond holders of the Special Purpose Company effectively get a piece each loan in proportion to their share/bondholding. The reasons why securitisation and CDOs take place and the mechanics thereof are not the point of this article. However, it should be clear that selling on the loans in this way reduces a bank’s imbalance between loans and deposits when it has a surplus of loans.
Banks lend to each other to address imbalances in the money deposited with them and lent out by them. They have several mechanisms for dealing with these imbalances:
- Interbank Money Money Market Lending and Borrowing
- Syndicated Loans and Loan Markets
- Securitisation and CDOs
These mechanisms, whist technically independent are not completely so. If for some reason banks are unwilling to lend to a particular banking organisation it is probably because they do not believe that organisation’s loans to its customers are very good. Hence trying to sell these loans via Syndicated Lending or Securitisation may not be fruitful either.