Thursday, November 13, 2008

"Base rates are now so low that our margins are desperately small"

The above quote has been nagging me because in the context of normal commerce it doesn't make sense. Its in the interest of banks that the credit market (mortgages, credit cards, personal and business loans) doesn't collapse leaving them with masses of non performing loans. And yet, they seem to have accepted this but not reducing their lending rates. it doesn't make sense...

Unless you compare with stock-led oil industry i.e. crude oil prices and petrol prices. Everytime crude oil prices go up, petrol prices go up almost straight away. But there is always stickiness when crude oil prices go down. The reason is two-fold. Stocks and secondly, pure profiteering.

In the banking sector, the Central Bank interest rate sets the signal for which way interest rates should go. In a perfect market, a 25% fall in Central Bank interest rates would instantly be reflected in borrowing and saving interest rates. If not the full 25%, then at least 15% with the 10% covering administrative costs...

Following the largest interest rate cut by BoE of 150bps (1.5%), most banks are saying that they can't reduce borrowing rates. Last Thursday's 150bps cut and equivalent fall in LIBOR should have led to a minimum cut of 50bps allowing for pure interest margin and administrative bps. Those that have reduced their rates (basically those needing capital from gova), have also stopped offering BoE rate tracker products to new customers. This despite LIBOR falling by a similar margin.

Banks are unwilling on unable to cut their rates by as much (and some not even at all) because

  1. Many want to reduce assets. By not offering lower priced lending products, they keep customers away. Also risk-averseness is now the name of the game and lower prices are now associated with growth in assets and risk.
  2. Cost of funding: Despite BoE best attempts, cost of funding remains high in wholesale funding market and inaccessible for some of these banks. HBOS, the largest mortgage lender with around 20% of the UK market is now seen as a basket case to which wholesale lenders will only lend to after its takeover by Lloyds TSB is completed.
  3. Broken funding models: In the old days before CDS tookover from sensible banking, most Treasury Divisions in a bank had a rolling hedging strategy that involved profiling of the maturity of its various lending products on offer at any given time (say monthly) and finding funding hedges to match that book through the yield curve. These days, doing such a hedging strategy can't be modelled let alone be used as its flout with difficulties because most banks have erroneously sold off loans whose downside somehow still sits with them.

The situation is not unique to the UK. In the US, banks are similarly pulling back from lending leading to a vicious circle in the housing market that is then negatively infecting the whole economy.

That is why I think that despite the mountainous sums given to banks, the end-game solution to this crisis lies in the housing market.


Ssembonge said...

The yield curve has never been this steep because banks have refused to adjust their rates but the rising insurance premiums may be the reason behind this anormally.

MainaT said...

If that the is the reason, the recession will a deep and more prolonged one.