Banks May Invoke “Market Disruption Clause” to Raise Rates

Reader a pointed us to an article in the Financial Times which we missed over the weekend, and a quick survey of blogs suggests we weren’t alone in overlooking it.

The article addresses an issue that has not gotten much airing, namely that Libor, which is currently at elevated levels thanks to the credit crisis, actually understates bank borrowing costs. This isn’t the first time we’ve heard that, since readers in comments complained bitterly that they lost 30-40 basis points on products that were priced off Libor versus their theoretical spread. Presumably the gap between Libor and actual funding costs is even worse now.

From the Financial Times:

Banks are looking at passing on higher funding costs to corporate borrowers by invoking an extraordinary clause in loan agreements triggered by market turmoil.

A growing number of banks are concerned that Libor – a benchmark for interbank borrowing costs and the base for calculating the interest rate for many corporate loans – is no longer accurate in reflecting their actual funding costs.

Some are now considering whether they can invoke a “Market Disruption Clause” in loan agreements on certain undrawn credit facilities, allowing to charge higher interest rates to borrowers…

The move comes as banks face a growing likelihood that they may have to extend more credit to corporate borrowers because of disruptions in other markets. General Motors and Goodyear Tire & Rubber have been seen in the past few days drawing down on their credit facilities.

Libor, which has been at highly elevated levels, is the pricing base for corporate loans with lenders charging a spread or risk premium over that rate….

A potential headache for banks is that many such facilities will have been agreed before the recent worsening in credit conditions at a fixed rate over Libor that may now be lower than a bank’s all-in cost of funding that facility.

A spokesman for the LMA confirmed it planned to contact the Bank of England about concerns about Libor and that it may not represent the members’ true cost of funds, but declined to comment further.

In general, loan financings will allow a syndicate of lenders to switch the rate at which they lend to a company to a level that represents their true costs of funds, with the support of at least a third of the syndicate. But it requires banks to disclose what they believe their own cost of funding.

However, individual banks are reluctant to complain that Libor rates are too low because it is tantamount to admitting other banks view them as a risky borrower.

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6 comments

  1. M

    The problem is not so much te elevated level of Libor and whether or not a bank can fund itself at that level, as well as the steepness of the curve. Where in the past a funding of 12M used to be equal to libor + or – a few basispoints, is it now easily libor + 30 or 40 bps.
    That means if a company borrows a sum for 12 months with a 1m resetting period, banks that not charge libor + 40 bps or more are actually losing on the hedge for that loan. Such a wide spread is not seen in years or even decades.
    With the coverage ratio rules, banks have to make sure that against a certain amounts of loans there is a deposit for a similar period.
    Past 1 year these funding pressure are increased even more since these days banks have to pay libor equivalents + a lot of bps to raise any funding for that maturity, even the so called good banks pay easily 50 bps over in maturities above 3 years.

  2. ft alpha

    Citigroup Inc. to Acquire Banking Operations of Wachovia
    FDIC, Federal Reserve and Treasury Agree to Provide Open Bank Assistance to Protect Depositors
    FOR IMMEDIATE RELEASE
    September 29, 2008 Media Contact:
    Andrew Gray (202) 898-7192
    angray@fdic.gov
    Citigroup Inc. will acquire the banking operations of Wachovia Corporation; Charlotte, North Carolina, in a transaction facilitated by the Federal Deposit Insurance Corporation and concurred with by the Board of Governors of the Federal Reserve and the Secretary of the Treasury in consultation with the President. All depositors are fully protected and there is expected to be no cost to the Deposit Insurance Fund. Wachovia did not fail; rather, it is to be acquired by Citigroup Inc. on an open bank basis with assistance from the FDIC.

    “For Wachovia customers, today’s action will ensure seamless continuity of service from their bank and full protection for all of their deposits.” said FDIC Chairman Sheila C. Bair. “There will be no interruption in services and bank customers should expect business as usual.”

    Citigroup Inc. will acquire the bulk of Wachovia’s assets and liabilities, including five depository institutions and assume senior and subordinated debt of Wachovia Corp. Wachovia Corporation will continue to own AG Edwards and Evergreen. The FDIC has entered into a loss sharing arrangement on a pre-identified pool of loans. Under the agreement, Citigroup Inc. will absorb up to $42 billion of losses on a $312 billion pool of loans. The FDIC will absorb losses beyond that. Citigroup has granted the FDIC $12 billion in preferred stock and warrants to compensate the FDIC for bearing this risk.

    In consultation with the President, the Secretary of the Treasury on the recommendation of the Federal Reserve and FDIC determined that open bank assistance was necessary to avoid serious adverse effects on economic conditions and financial stability.

  3. Matt Dubuque

    Matt Dubuque

    I would argue that such a rise in interest rates is NOT inflationary.

    Just the opposite.

    Will this rise in interest rates spur consumer demand?

    Every indicator I see shows that we need to be vigilant against a deflationary burst, which is now highly likely.

    The Fed quarterly survey of lending expectations due out in October should confirm this.

    Matt Dubuque
    mdubuque@yahoo.com

  4. Anonymous

    Matt, I agree. An increase in interest rates will not increase consumer demand.

    A rise in interest rates at this point will be another blow to American Business and add to the problems of state and local government budgets in short order, imo. The problems confronting Main St are getting more serious with this move.

    River

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