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A quick guide on how the Libor Base rate differential affects retail savings and loans.
Note: Basis risk occurs when you pay one interest index and receive another. The following looks at just one aspect of a particular type of basis risk. The reference currency is GBP. Similar issues occur for retail institutions whose base currency is EUR or USD. Recently 3 month Libor has been trading at a substantial premium to Base rate. On 20th June 2008 3 month Libor was 5.95% whilst Base rate was 5.00% a differential of 95 basis points. Historically this is unusual the differential is normally in the range of 10 to 20 basis points with the gap often narrowing when markets are expecting rate cuts. Why is Libor so high? Its the fall out from the credit crunch. Banks are finding it hard to borrow wholesale money, many markets are closed and the interbank market is at best difficult.
Windfall gains
For a firm receiving Libor and paying Base rate (as in the example) this leads to a substantial benefit. A gain equivalent to 9.5m per annum for every 1 billion hedged. (Treasury or retail lending performance is enhanced depending on internal transfers). In the current environment any windfall gain is welcome. So whats the problem? Its an issue of dependence. It is impossible to say with any certainty how long you can rely on this additional revenue. It is largely dependent on confidence in the financial system. As long as banks find it difficult to borrow Libor rates will probably remain elevated.
Basis risk
Basis risk naturally occurs in the balance sheets of many firms. In normal market conditions basis risk is often overlooked, the index you receive is assumed to be correlated to the index you pay and the risk is regarded as small. Then just when you considered conditions benign it strikes. Basis risk gives you gains or losses dependent on the structure of your balance sheet. In many cases the outcome is largely one of luck rather than judgment.
Management implications
If you have senior management responsibilities you need to ask a few questions. Are we running a basis risk? How big is that risk? What are the implications? What can and should we do about it?
Your risk management department should be able to answer the first two questions by providing some straightforward explanations with the accompanying metrics. Lets cut to the interesting stuff. Suppose you are running a significant basis risk what are the implications? 1. Earnings from basis risk are not a substitute for core business. Do not assume this benefit is ongoing. These are not quality earnings. If and when the Libor-base rate differential narrows the windfall gain will evaporate. Be prepared and dont blame the dealers. You can afford to pay higher rates for retail deposits. Libor is higher than Base rate so you are in a situation where you can consider paying depositors rates that exceed Base rate. In order to secure retail funding some institutions are already doing this. Its one of the reasons why retail depositors are being offered some very attractive savings rates. Consider whether hedging the basis risk is appropriate. You have alternatives-you can leave the situation as it is, hedge some of the risk or hedge all of the risk. Remember doing nothing is a decision, it implies you anticipate the differential to remain historically wide. The use of basis swaps is explained later.
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Hedging may leave you worse off. If you decide to hedge and the Libor-Base rate differential widens you will be worse of than competitors with the same risk that chose not to hedge. These issues should be discussed at the appropriate committee with the suitable action being agreed.
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Base rate
Libor
Base + 40 bp
Libor
William Webster Barbican Consulting Limited Financial Markets Training wwebster@barbicanconsulting.co.uk 00 44 (0)20 79209128
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