The credit crunch is undeniably having a huge impact on peoples finances, and with credit being harder and harder to obtain, the general focus is now on interest rates and how they will affect the individual. LIBOR, once only heard of in financial circles, is now the hot topic of conversation across the nation, as media coverage speculates on the possible outcomes of financial aid packages.
It is now common knowledge that LIBOR, or London Inter Bank Offered Rate, which indicates the rate that the financial institutions borrow from each other, is the true reflection of how the world markets are reacting to the changing conditions within the sector.
The British Banking Association (BBA) takes the inter-bank borrowing rates from 16 contributor panel banks and looks at the middle eight of these rates (discarding the top and bottom four) and uses these to calculate an average, which then becomes that day's BBA LIBOR rate.
Over the past 12 months, the difference between the LIBOR rate and the Bank of England borrowing rate has been rather large, and has gone on for longer than ever before. However, in recent weeks this gap has closed somewhat. Recently, a drop of 1.065 brought the rate to 4.496, the lowest since April 2004, which came hot on the heels of the Bank of England slashing rates by 1.5% to bring rates to a low of 3%. Since these moves, there has been huge pressure from both the government and the media on other lenders to drop their rates accordingly. Several major banks have now shown a commitment to follow in the footsteps of the Bank of England's drop in rates.
But there would appear to be several things that have been overlooked in the rush to pass on the perceived benefits of the drop in the base rate.
Current customers will of course welcome a reduction in interest rates. For the bank, however, this can have a damaging effect on arrears performance. As borrowers are set to pay less monthly, this automatically puts up arrears percentages. For example, if a borrower normally pays 350 a month, but is 300 behind, they are effectively not an issue as yet. However, if those monthly payments are brought down to 290, that 300 in arrears is considered to be over a month's worth of payment, which then puts them on the problem list. This will have a knock-on throughout, as people who are 1month behind move to 2, 2 to 3 and so on. Therefore, the amount of people being litigated against will also increase.
Those bank's wishing to lend to other bank's at the LIBOR rate will take in to account the performance of the borrowing bank's mortgage book. This will have deteriorated considerably as a result of the rate cut and will deteriorate further with future cuts. This will obviously have a detrimental effect on a bank's willingness to lend, and could have a negative impact on LIBOR rates as the perception of risk increases, this will be priced accordingly.
This isn't the only way banks get funds though. Loans and mortgages are also funded by retail deposits and the moneys accumulated in the existing loan book. Those banks that have carried on functioning recently have done so based on retail funding. At the moment, the drive we saw in the past for mortgage business is now being focused aggressively on investment business.
The drop in rates will mean that the income derived from borrowers will plummet, although banks will continue to grapple for investment business. Therefore the bank's profits will droop and their recovery will be made slower. As the banks fight for investment, the rates drop even below the LIBOR rate, meaning that the only way for banks to get liquid funds is through retail business. In that respect, LIBOR must then drop far enough to be attractive to banks in comparison with the cost of getting in retail business.
In conclusion it is fair to say that the Governments strategy has had a positive impact on the market and will provide much needed confidence. However it is also fair to stay that there are still many challenges ahead and the antidotal injection of cash and reduction of interest rates will certainly come with some painful side effects. On a side note while I write this, LIBOR has actually gone back up to 5.65% go figure! - 15224
It is now common knowledge that LIBOR, or London Inter Bank Offered Rate, which indicates the rate that the financial institutions borrow from each other, is the true reflection of how the world markets are reacting to the changing conditions within the sector.
The British Banking Association (BBA) takes the inter-bank borrowing rates from 16 contributor panel banks and looks at the middle eight of these rates (discarding the top and bottom four) and uses these to calculate an average, which then becomes that day's BBA LIBOR rate.
Over the past 12 months, the difference between the LIBOR rate and the Bank of England borrowing rate has been rather large, and has gone on for longer than ever before. However, in recent weeks this gap has closed somewhat. Recently, a drop of 1.065 brought the rate to 4.496, the lowest since April 2004, which came hot on the heels of the Bank of England slashing rates by 1.5% to bring rates to a low of 3%. Since these moves, there has been huge pressure from both the government and the media on other lenders to drop their rates accordingly. Several major banks have now shown a commitment to follow in the footsteps of the Bank of England's drop in rates.
But there would appear to be several things that have been overlooked in the rush to pass on the perceived benefits of the drop in the base rate.
Current customers will of course welcome a reduction in interest rates. For the bank, however, this can have a damaging effect on arrears performance. As borrowers are set to pay less monthly, this automatically puts up arrears percentages. For example, if a borrower normally pays 350 a month, but is 300 behind, they are effectively not an issue as yet. However, if those monthly payments are brought down to 290, that 300 in arrears is considered to be over a month's worth of payment, which then puts them on the problem list. This will have a knock-on throughout, as people who are 1month behind move to 2, 2 to 3 and so on. Therefore, the amount of people being litigated against will also increase.
Those bank's wishing to lend to other bank's at the LIBOR rate will take in to account the performance of the borrowing bank's mortgage book. This will have deteriorated considerably as a result of the rate cut and will deteriorate further with future cuts. This will obviously have a detrimental effect on a bank's willingness to lend, and could have a negative impact on LIBOR rates as the perception of risk increases, this will be priced accordingly.
This isn't the only way banks get funds though. Loans and mortgages are also funded by retail deposits and the moneys accumulated in the existing loan book. Those banks that have carried on functioning recently have done so based on retail funding. At the moment, the drive we saw in the past for mortgage business is now being focused aggressively on investment business.
The drop in rates will mean that the income derived from borrowers will plummet, although banks will continue to grapple for investment business. Therefore the bank's profits will droop and their recovery will be made slower. As the banks fight for investment, the rates drop even below the LIBOR rate, meaning that the only way for banks to get liquid funds is through retail business. In that respect, LIBOR must then drop far enough to be attractive to banks in comparison with the cost of getting in retail business.
In conclusion it is fair to say that the Governments strategy has had a positive impact on the market and will provide much needed confidence. However it is also fair to stay that there are still many challenges ahead and the antidotal injection of cash and reduction of interest rates will certainly come with some painful side effects. On a side note while I write this, LIBOR has actually gone back up to 5.65% go figure! - 15224
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