Bank stability is absolutely critical to an economy. Banks are usually private organisations, whose principal purpose is making profits for shareholders. From the late 1980s forward, banks diversified into a wide range of financial services products. Various sections of banks engaged in more complex merchant banking-type transactions.
Historically, banks funded their loans through retail deposits. However, following the introduction of the euro and developments in international banking markets, banks were enabled to obtain alternative sources of funding using the wholesale markets. The wholesale banking market typically involves interbank lending, sale and repurchase agreement, debt issuance, foreign exchange and derivative trading.
The principal problem in the Irish credit crisis was a lack of funding caused by a combination of the international credit market’s position and a collapse in the values of loans and security following a prolonged credit bubble. The banks lacked the solvency to obtain funding at just the time when the funding crisis became acute.
Interbank lending has been the most important means by which banks obtain short-term non-deposit funding. Financial centres establish rates at which banks are prepared to lend to each other.
The Euro Interbank Offered Rate is the offer rate for deposits in euro. The LIBOR is the London Interbank Offered Rate for deposits. LIBID is London Interbank Bid Rate which is the rate at which banks are prepared to borrow funds from each other. Bid rate will be likely to be slightly smaller than the offer rate.
Interbank loans are typically unsecured. However, even before the credit crisis secure transaction or collateralised transaction became more common through so called repos (see below).
In 2008, a significant gap opened between secured repo backed borrowing and unsecured borrowing. They arose due to concerns regarding counterparty risk of insolvency.
Bank capital is the difference between assets and liabilities. See the separate sections in relation to mandatory bank capital. Bank capital should in principle, equate to available assets which are a buffer against various risks.
Financial institutions may raise monies by issuing bonds and securities. This is equivalent to deposits in one sense as the bank owes the debt. However, the debt is saleable. Debt securities may be issued as short term securities for periods of less than one year (known as money market instruments) or longer term securities with maturities of five years or more.
Money market instruments include certificates of deposit, commercial paper and treasury bills. Certificates of deposit are negotiable instruments with minimum maturities of seven days. They represent deposit funds for a specific period, earning a specific interest rate which fixed.
Commercial paper is short term debt issued by financial institutions or large corporations with varying lengths of maturity. It may be rated by rating agencies and marketed through dealers. Interest on commercial papers tends to be at less than bank lending rates, so that it represents a more attractive form of funding. Bond rates are fixed and may have a credit rating in the case of larger issuers.
Rating agencies assessed credit risk and gave ratings based on the strength of the issuer. Many ratings issued by agencies were shown to be highly flawed in the financial crisis. Certain risks were completely underestimated.
Credit rating agencies were subject to conflicts of interest in that issuers were responsible for paying them so that an agency could become more successful by giving higher ratings. Credit ratings are now subject to regulation dealing with matters such as conflict of interest, transparency, independence, fee structures and supervision.
Following the financial crisis, European Central Bank maintained its base rate at historically low levels. This has reduced interest rates generally and caused institutional investors such as pension funds, insurance companies to seek high returns with other issuers.
Repurchase or a repo transaction is a quasi-security transaction. A buy/sell back transaction is an outright sale of securities by the seller to the buyer and a simultaneous agreement to purchase the same quantity back at a future date.
The difference in price and timing marks an implicit interest rate. Traditionally, the transactions were separate, were documented as outright sales and purchases. This carried greater risk in that one obligation was not conditional on the other which could have adverse effects on insolvency.
A classic repo transaction is a sale of securities for cash with an obligation buyback an equivalent amount of securities at a future date on the repurchase date. The repurchase price is delivered, and the buyer delivers an equivalent amount of securities. The buyer’s return is the repo rate. The seller retains the risk of variations in price because the price is set at the outset.
The length of a transaction may vary from overnight to a year. More common transactions are for very short periods from overnight to a month.
The repurchase repo transaction is effectively a security transaction. If the party fails to buy, the securities are lost to him and act as quasi security.
The ISMA published a standard form of repo transaction, the global repo document, the global master repurchase agreement. The global master repurchase agreement provides that if the value of securities held by the purchaser falls, a margin call may be made requiring transfer of additional margin on security. Accordingly, additional security is automatically called in.
Parties mark the transaction to the market daily and may make varying margin calls. The close-out netting provides that if an event of default occurs, the transaction is terminated, and the obligations are accelerated. Parties can calculate amounts due in each transaction and set off all sums to arrive at the net sums.
In a repo transaction, the securities are transferred from the seller’s custodian to the buyer’s custodian or equivalent holder and reversed on the repurchase date. There may be an independent third party who administers the exchange of cash and securities and the margin arrangements. Euroclear Bank and Clearstream offer tripartite repo services.
A number of important liquidity measures have been introduced as a result of the financial crisis. The liquidity coverage ratio seeks to ensure banks have sufficient high quality liquid assets to cover cash outlays for 30 days in a distress scenario. The obligations have been phased.