False profits

Free money is usually a good thing. So three-month unsecured loans carrying less than one percent interest would normally be thought of a boon for banks. It allows US banks to borrow cheaply and lend for several percentage points more – giving them a way to earn their way out of their current troubles. The problem is, the interbank rate is low largely because the government is propping up the industry. When it rises to a market level that reflects banks’ true state, it could crimp their earnings.

The three-month dollar London interbank offered rate fell to a multi-year low of 66 basis points on May 21. That’s good for owners of the $360 trillion of debt tied to the rate. It’s also good for banks that borrow in the interbank market to fund their loans to customers. They should be making out like bandits.

But a major reason for Libor’s swoon – apart from falling risk aversion among banks – is the Federal Reserve’s many emergency lending facilities, which have reduced the risk that any major bank will suffer serious problems. When the Fed withdraws these initiatives, the cost of funding bank loans will increase – especially while banks are still working through their difficulties. If banks have been too aggressive in pricing the loans they have made, the rising cost of funding them might make the loans uneconomical.

That’s what happened in the Savings & Loan crisis in the late 1980s. A repeat could cause significant trouble for the US banking system – just when a rebound is on the horizon. True, it’s hard to price a loan too richly when the cost of funds is low, not least because competitors will race to undercut you. But only those banks that build in big enough margins will still have profitable loan books when rates start to rise once again.