LIBOR and the Bank of England


Q. What is the difference between the Bank of England rate and LIBOR?

Share

A: The Bank of England base rate sets the market for lending. The Bank of England rate is the rate at which the Bank of England is willing to make secured loans (given gold-plated collateral). The Bank of England will intervene in the markets for secured lending to keep the rate for secured lending at that rate - they will make unlimited loans available while the market rate is above base, and they will borrow money if the market rate is below base.

A bank short of cash can present a gilt to the Bank of England, and the Bank of England will then lend cash at the base rate. This is a loan but in technical terms it is called a 'repo' or 'repurchase agreement' - this is because of the legal setup; the Bank of England actually buys the gilt, and the bank agrees to buy the gilt back at a specific price (price paid plus interest) on a specified date in the future. This makes it absolutely clear that the Bank of England has control of the gilt and avoids any petty legal wranglings if the loan is defaulted on. (So, while it is true that the Bank of England does buy and sell gilts, it does not buy and sell in the true sense - it only does so to legally exert control over the collateral pledged for cash).

For other loans the interest rates will depend on the price of risk and the price of 'risk-free' money. The Bank of England lends money at no risk to itself because it accepts only the very best collateral which are in effect gilts. This therefore sets the price for all other interest rates.

For instance, if the Bank of England sets the base rate at 5%, then if a bank wants to lend money for less good collateral, it has to do so at an interest rate higher than 5%. If a bank on the other hand wants to make a loan and accept collateral with a 1% risk of loss, then if bank charges 1% they will, on average, breakeven - however, they can get 5% 'profit' risk free, so in practice they would have to price a loan at 5% + 1% risk + profit margin. i.e. 6 plus a bit %.

The Bank of England will actively defend the price of loans based on gilts as collateral. They will check the markets, and if banks are demanding a high rate of interest (e.g. 5.5%) the Bank of England will flood the market with loans at a lower rate (for instance. 4.5%) to bring the average price back to the base rate. In this way, they ensure that the price of 'risk free' short term money stays as close to the base rate as possible, even though this money may be traded in a free market.

LIBOR is is a charge for unsecured lending. Consequently, LIBOR will be higher than the base rate, as it includes an additional cut which represents the cost of the risk to the lender. The reason for the recent disconnect between the two, was that the perception of risk has been steadily increasing and has been increasing faster than the Bank of England had been cutting. Indeed, in the first few cuts, there may have been a feeling that 'OMG - the Bank of England are cutting rates, something's up, panic. Pull your money out', which forced the price of risk up at the same time.

It's worth noting that the usually quoted figure for LIBOR is the 3 month LIBOR - in other words a 3 month fixed rate - that takes into account what the market thinks the Bank of England will do over the next 3 months, as well as what the market things the overall level of risk will be.

Here's a great analogy of how a bailout package works!
It is a slow day in a damp little Irish town. The rain is beating down and the streets are deserted. Times are tough, everybody is in debt, and everybody lives on credit.
- On this particular day a rich German tourist is driving through the town, stops at the local hotel and lays a 100 note on the desk, telling the hotel owner he wants to inspect the rooms upstairs in order to pick one to spend the night. - The owner gives him some keys and, as soon as the visitor has walked upstairs, the hotelier grabs the 100 note and runs next door to pay his debt to the butcher. - The butcher takes the 100 note and runs down the street to repay his debt to the pig farmer. - The pig farmer takes the 100 note and heads off to pay his bill at the supplier of feed and fuel. - The guy at the Farmers' Co-op takes the 100 note and runs to pay his drinks bill at the pub. - The publican slips the money along to the local hooker drinking at the bar, who has also been facing hard times and has had to offer him "services" on credit. - The hooker then rushes to the hotel and pays off her room bill to the hotel owner with the 100 note. - The hotel proprietor then places the 100 note back on the counter so the rich traveller will not suspect anything. - At that moment the traveller comes down the stairs, picks up the 100 note, states that the rooms are not satisfactory, pockets the money, and leaves town. - No one produced anything. No one earned anything. However, the whole town is now out of debt and looking to the future with a lot more optimism. - And that, Ladies and Gentlemen, is how the bailout package works!

Q. If the BOE can simply make unlimited loans to keep LIBOR down then why haven't they done it before to control LIBOR if it were so easy?


Is it because no bank had any decent collateral with which to get this Bank of England lending and/or it was in fact simply still too expensive despite LIBOR being even higher?

A: The Bank of England doesn't lend at LIBOR - because LIBOR is the interest rate for loans with risk. The Bank of England, ignoring the special schemes, only lends on risk-free loans - i.e. a loan to a bank that has lodge a government gilt as collateral. (A government gilt is an IOU from the government for a certain amount of cash at a certain date in the future - as a result it is 100% guaranteed by the government, and is therefore as risk free as an investment could realistically get). [Gilts are a nice investment for banks, because they are easily bought and sold, pay a long-term fixed interest rate, and are ultra-safe. However, they are long term, and tie up money for anything up to 50 years - and since they are not cash, not many people take them as payment for goods or services. Because they are so secure, other banks, including the Bank of England, are happy to take them as security for a loan of cash. This means if a bank needs temporary cash to cover withdrawals, etc. then it's easy to convert a gilt into cash, either by pawning it to another bank or Bank of England, or simply selling it].

The Bank of England aims to manipulate the market for risk-free loans, so that the market rate is as close to the base rate as possible. The Bank of England doesn't touch the LIBOR money market for normal loans (although in recent months, the Bank of England has bailed out the money market to try and keep it operating).

The point is that there is a link between LIBOR and the Bank of England lending rate. If you make a loan, and you reckon that there is a 1 in 100 chance per year that you will lose your money because the loan cannot be repaid - you will want extra interest to compensate you. A 1 in 100 possibility works out at a 'spread' of 1% - so if you lent your money at base rate + 1%, then, on average over thousands of loans, you would be roughly even with having just lent your money risk-free at the risk-free rate. If you lend at less than a 1% 'spread' then you will lose money (because the extra interest would not be sufficient to cover your losses), and if you lend with a spread larger than 1%, then you make a nice profit, but your offer of a loan isn't competitive. This means, that if the risk stays the same, your target interest rate should be close to 'risk free rate' + 1%. In other words, the risky lending rate should track the risk free lending rate - as long as the risk stays the same.

Because base rate is only applicable to risk free loans, you have to have risk free collateral to take advantage of it. Risk free investments tend to have poor returns - while gilts do pay interest, it is a very modest rate, so banks don't like to keep too many of them around. Mortgages give a better return, but as collateral they are risky, so you don't qualify for the risk free rate - this means you'll have to look for a loan at LIBOR.

So, although the Bank of England is able to control the risk free lending market, there is only relatively little money loaned out, as there is relatively little risk free collateral around. The vast majority of money is lent between banks with less collateral, at the LIBOR rate. LIBOR is dependent on 2 things - base rate + risk.

In the last few years, it was as if money was growing on trees (or perhaps houses), and bankers couldn't see any risk anywhere, so they were offering and taking loans based on extremely low risk prices - 0.2%, 0.1% sometimes even less. When the sub-prime s**t started hitting the fan in the US, the bankers suddenly realised that their risk price was wrong, so the price of risk jumped from 0.1% to 1.5% or more. The result was that banks like Northern Rock, Bradford & Bingley and Alliance & Leicester popped, because other banks had priced their risk so high, they wouldn't lend to them at all.

Bad news keeps creeping in after more bad news, followed by even worse news. The price of risk has been progressively creeping up, month by month. This is why the LIBOR rate appeared to have disconnected from base rate at one point - particularly, as a 0.25% base rate cut, would simply be swallowed up by a rise in risk price by 0.25%, leading to LIBOR getting stuck. Note that the LIBOR and Bank of England rates are 'normally' a mere fraction of a percent apart (l heard 0.2%), the recent and current disconnect of the credit crunch being highly anomalous.

Q. Is government borrowing inflationary?

A: Ok, mind you this will be a bit long -:

When the government sells bonds, it is deflationary. This is because the bonds are bought with existing money.

When the government buys bonds, it is inflationary. This is because the government (or Bank of England) buys bonds with newly printed money. So the government expands the money supply by issuing bonds, selling them, and buying them back with newly printed money.

Why?

You have to spend it for it to be inflationary.

Say you have a 100k mortgage and zero savings you remortgage your house and take out (MEW) 100k.

So now you have 200k mortgage and 100k savings. You have just increased the money supply. This doesn't change anything in the pure sense so there is no inflation at this point. If you then go and buy a car with the money it can cause inflation... Government buying its bonds is the legitimate method for increasing the supply of narrow money in circulation.

The government borrows by issuing gilts. The gilts have to be bought with cash (or electronic transfer of cash equivalent). Hence, it merely moves cash into the hands of the government rather than creating it.

If a foreign government wants to buy gilts, they first have to change their currency for sterling, or use their sterling reserves. This doesn't create sterling, and if foreign investors want enough gilts, they may end up pushing up the price of sterling.

So in theory the currency weakens (inflation) when the market expects more Sterling to enter the system. When Government issues debt this signals extra currency provided two conditions are met:

i) Firstly, the Government is not expected to be able to pay the debt using taxation of the general population. It will either default or...

ii) The Government is expected to 'monetise the debt' with new money issued by the central bank (rather than to default on the debt).

Once these two conditions are met by sentiment in the market Sterling will buy you less house, less land, less gold, less oil, less food...

The issuance of government bonds is a recognised way to limit the inflationary power of central bank interventions. E.g. the Bank of England doesn't lend cash in its 'special liquidity scheme'. To lend cash is potentially inflationary, if the cash wasn't in general circulation. To get around this, the BoE lends gilts. Gilts aren't cash, and if the banks want to convert their mortgages to cash via gilts, they have to swap the gilts, on the open market, for cash that is already in circulation. The federal reserve has a similar approach with its liquidity injections. In the case of the Fed, they lend cash - but every time they lend cash, they sell a government bond. The result is that although their loans introduce cash into circulation, the sale of bonds drains the cash from somewhere else, so the total amount remains constant.

However, there may be more subtle effects. Some of the cash that may end up buying gilts may be 'idle'. It may be long-term savings that are being accumulated, e.g. for a pension or other future use. While the cash sits idle in a bank account, it performs relatively little work. However, if invested long term into gilts (as a safe investment) then it may end up recycled back into the general economy, thereby increasing the amount of cash in active use. This is a modest effect, and the same effect would occur when the money is withdrawn from the savings and spent - it just happens earlier.

 ...Spread Betting on Interest Rates


Recommend this on Google

The content of this site is copyright 2016 Financial Spread Betting Ltd. Please contact us if you wish to reproduce any of it.