The London InterBank Offered Rate, commonly referred to as LIBOR, has been a pervasive interest rate in financial products for two generations—and is set by a group of banks that transact between each other in London.1 Many floating rate mortgages, interest rate swaps, repurchase (repo) agreements and bank loans (syndicated and otherwise), have their interest rates reset to LIBOR, usually with a spread. In fact, there are trillions of dollars’ worth of securities, derivatives and loans outstanding tied to LIBOR.
What is happening in the LIBOR?
Spikes to LIBOR tend to get noticed by market participants—particularly, after the global financial crisis when LIBOR was seen as the figurative “canary in the coal mine.” Recently LIBOR has spiked again (Exhibit 1), as our chief investment officer, Krishna Memani, noted in a recent blog. But the canary is quite healthy; it’s the coal mine that has run out of coal.
To explain in detail what is happening to LIBOR, we must study what we see as the root cause―namely new Money Market Mutual Fund rules mandated by the industry’s regulator, the Securities and Exchange Commission (SEC).
A recap of money market reform
In 2014, the SEC passed new rules that went beyond 2010 reforms, which had already substantially changed the way money market funds operate.2
On October 14, 2016, this last round of the 2014 rules will come into effect and introduce two primary changes:
- Prime institutional money market funds (MMFs) will need to begin reporting floating net asset value (FNAV) on a mark-to-market basis. This means that the $1 share price that had been a staple of the mutual fund industry since the 1970s will no longer apply to these funds. Prime funds generally hold commercial paper and other short-term debt issued by companies and financial institutions.
- Fund boards will be given the discretion to limit redemptions and impose fees under certain conditions, such as when liquidity buffers are being breached during times of stress.
For many institutional shareholders, FNAV and redemption gates are unappealing options for what are supposed to be highly liquid (or “same-day cash”) vehicles. This has led to some major changes in the money market industry.
How the landscape is changing
The first and quite noticeable change has been a large shift of assets from prime to government MMFs. A large part of this shift so far has been from fund families converting their offerings from prime funds to government funds, while investors in some cases have also moved assets out of prime funds (Exhibit 2).
A second major change is that prime funds are positioning themselves for large outflows over the next several months. There has been little movement to date on shareholder flows, but some traction is building as we approach the October 14 deadline. Estimates vary, but many predict hundreds of billions of dollars in outflows. Therefore, many prime funds have proactively reduced their weighted average maturity (WAM) and weighted average life—both of which are now at all-time lows—and are increasing fund liquidity (Exhibit 3). Flows have also been occurring as investor money is beginning to move out of funds that have chosen to remain institutional prime funds. More assets are anticipated to shift as we approach the October 14 date for the new rules to take effect.
The impact on bank funding and LIBOR
As this date approaches—and with uncertainty surrounding investor appetite for FNAV—money market fund managers are keeping their maturities short of the deadline (Exhibit 4). Given that the most commonly used LIBOR is the three-month rate, we’ve already passed a Rubicon in mid-July, and now banks can no longer readily obtain three-month funding from money market mutual funds.
Therefore, the funding costs of terms beyond October 14 have increased as demand for this tenure of debt has declined, which is resulting in higher funding costs for banks—a trend reminiscent of, but slower than, what happened during the 2008 financial crisis. Still, the environment today is significantly different from what it was back then, when investors were worried about:
- the ability of banks to fund themselves;
- declining prices of bank-held assets; and
- capital shortfalls due to losses.
Today, the increase in funding costs is only modest; asset prices are generally stable or rising; and banks have much more equity thanks to new capital regulations instituted by the Basel Committee on bank supervision, which sets international banking regulations.
To highlight how the financial sector has changed since 2008, here are some of the new rules that support the financial sector’s balance sheets today versus a decade ago. They include:
- A liquidity coverage ratio: Banks have to hold enough liquid assets to cover a month’s maturities.
- A net stable funding ratio, which forces banks to issue more longer term debt or hold deposits instead of using short-term instruments like repurchase agreements or commercial paper.
- A new risk-weighting regime for assets: Banks must hold more equity capital against most assets on their balance sheet. Even government securities have risk weights attributed to them—and there are new weights attributed to counterparty and operational risks.
- Decreased leverage: The total size to which banks’ balance sheets can grow relative to their equity has been reduced by the latest Basel rules as well.
- Total loss absorbing capital: Banks must make provisions to have some debt subordinated to depositors in the event of a worst-case scenario.
As we approach October 14, further increases in the LIBOR could occur, particularly against other products not tied to bank funding, such as the Federal Funds rate (the interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight) and Treasury bills (or T-bills, which are short-term debt obligations backed by the U.S. government with a maturity of less than one year). However, it is possible that the LIBOR’s move will be capped or mitigated by some of the new capital rules or the use of central bank funding lines. Foreign banks may also divest their U.S. assets and reduce their need for dollar funding.
Moves in the LIBOR are not likely over and will continue making news for some time to come. However, when looking at the current move against Treasury bills, the move is hardly noticeable and, in our view, does not represent a significant threat to the banking system or broader economy (Exhibit 5).
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1 Since the 2008 global financial crisis there have been some changes to the way the rate is calculated to make it, ironically, less transparent but probably more representative of the dollar funding cost at mid-day, City of London time.
2 The 2010 rules focused on shorter weighted average maturity (WAM), added a maximum weighted average life (WAL) and a number of other rules intended to make it less likely that money market funds would find themselves without liquidity during times of financial stress.
Mutual funds are subject to market risk and volatility. Shares may gain or lose value.
The London Interbank Offered Rate (LIBOR) is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. It is a primary benchmark for short- term interest rates around the world.
The Crane Prime Retail Money Fund (MF) Index is produced by Crane Data and represents the average yield, maturity and other characteristics of all money market funds subsets thereof available to retail investors.
The Crane Prime Institutional Money Fund (MF) Index is produced by Crane Data and represents the average yield, maturity and other characteristics of all money market funds subsets thereof available to institutional investors.
The indices are unmanaged, include the reinvestment of dividends and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results.
An investment in money market funds is neither insured nor guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although money market funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.