One of the most noticeable impacts of globalization has been the rapid increase in capital flows in terms of either foreign direct investment or portfolio investment. Responding to the changes in moving toward a more globalized system, many governments rapidly liberalized their economies first by removing exchange-rate controls during the decade of the 1980s, then by opening financial-services industries, exposing them to foreign competition. This resulted in banks no longer being limited by depositors’ funds to meet the ever-increasing demand for credit. Approximately 10 years after this liberalization, a significant increase in the use of debt funding via global capital markets was evident, forcing the unification of a more global banking system—as we all know it today. Well-functioning global bank debt-funding markets are crucial in supporting the ever-increasing wholesale-funding appetite of large banks.
Post the 1990s, the world has seen further increases in debt-issuance activities by financial institutions in financial markets, not only due to the diversity of the available financial instruments, such as wholesale funding, but also the wide range of funding instruments made available to fund credit growth. This has enabled firms to diversify their capital-raising activities through equity financing but also allowed greater access to debt funding domestically and off-shore. Since banks around the world have shifted from a more conservative asset-side management to liability management, this has resulted in a greater reliance on domestic and international wholesale-funding markets, enabling banks to fund their excess credit growth, particularly where deposit funding is scarce. The global financial crisis and subsequent recovery of wholesale-debt markets raised fundamental questions—in particular, the linkage between US interbank funding markets and equivalent interbank funding markets worldwide.
Wholesale funding allows banks to expand beyond the use of conventional deposit funding to increase the capacity of lending beyond the constraints of the fixed local depositors’ base. Specifically, it uses a financial debt instrument certifying a contract between the borrower and the lender as documented in the debt-securities indenture creating a legally enforceable obligation and may be ranked according to its seniority (senior or subordinated). Investors evaluate the issuer’s default risk and price this into the debt security, which is commonly referred to as the funding spread (all-up yield minus benchmark market rate—i.e., LIBOR [London Interbank Offered Rate]).
Banks’ use of debt funding allows an efficient composition of a bank’s capital ratios by maintaining adequate funding sources versus regulatory requirements and meeting rating-agency expectations. Furthermore, and as part of the Bank for International Settlements (BIS) key reforms in fostering a strong banking system, banks are required to maintain a net stable funding ratio (NSFR). Primarily, the NSFR is aimed at ensuring banks do not rely too heavily on short-term wholesale-funding instruments and, hence, encourage banks to hold more stable, longer-term wholesale funding (Basel Committee on Banking Supervision [BCBS], 2014)1Bank for International Settlements: Basel Committee on Banking Supervision: “Basel III: the net stable funding ratio,” October 31, 2014. (https://www.bis.org/ Accessed April 5, 2021).
Typically, a bank’s wholesale-funding activities are centrally managed by their treasury departments and aim to achieve diversity of funding across maturities, currencies, investor types, markets (retail and wholesale), geographical locations and funding-instrument types. The main funding instruments include certificates of deposits, commercial paper, extendable notes, senior unsecured debt, covered bonds and subordinated debt, including hybrid capital and securitization.
Citing a recent research paper I published with colleagues (Cottrell et al., 2021)2Journal of Banking and Finance: “What determines wholesale funding costs of the global systemically important banks?”, Cottrell, S., Yu, X., Delpachitra, S. & Ma, Y., Volume 132, Article Number 106197, Pages 1-17, 2021, we investigated drivers of wholesale-debt funding spreads using credit default swap (CDS) data from the global systemically important banks, referred to as G-SIBs. G-SIB classification is determined using five main criteria: cross-jurisdictional activity, interconnectedness, size, substitutability and complexity. Each of these five classifications of systemic importance receives equal weight in the computation of the numerical score that each bank in the sample receives in terms of its relative systemic importance. These indicators are then totaled and used to calculate the scores of banks in the sample. The cut-off score to be classified as a G-SIB is 130 basis points (see Table 1).
Using a cross-country analysis comprising 25 G-SIBs in 12 countries over the last decade, we analyzed whether domestic and foreign interbank funding markets impact the costs of wholesale funding using the CDS spreads on five-year senior debt issues across multiple regions, including the United States, United Kingdom, Europe, Japan, Canada, China and Australia. Table 2 presents a profile of each G-SIB’s outstanding wholesale-debt funding, market capitalization and debt to equity (D/E) in $US millions. It shows that the outstanding wholesale debts issued by G-SIBs amounts to just over $US 3 trillion, and, of that, around $US 2 trillion is senior-rated debt, which became the focus of our research.
The rationale for using the CDS spread as an alternative to the actual wholesale-funding spread on various debt instruments issued by a G-SIB is well documented in the academic literature. For example, research (Darrell, 19993 Financial Analysts Journal: “Credit swap valuation,” Darrell, D., Volume 55, Issue 1, Pages 73-87, 19; Hull and White, 20014CFA Digest: “Valuing credit default swaps I: no counterparty default risk,” Hull, J. & White, A., Volume 31, Issue 2, Pages 91-92, 2001)5Journal of Financial Stability: “Solvency and wholesale funding cost interactions at UK banks,” Dent, K., Hoke, S.H. & Panagiotopoulos, A., February 2021. (https://www.sciencedirect.com/science/article/pii/S1572308920300991?dgcid=rss_sd_all#bib0055) suggests that an approximate measure to a no-arbitrage opportunity, all else being equal, finds the CDS spread should be identical to the credit spread between the yield to maturity on a risky par bond and the benchmark risk-free rate. Chen et al. (2009)6The Review of Financial Studies: “On the relation between the credit spread puzzle and the equity premium puzzle,” Chen, L., Collin-Dufresne, P. & Goldstein, R. S., Volume 22, Issue 9, Pages 3367-3409, September 2009. described a CDS spread as a purer quantification of credit risk than the equivalent bond spread due to the swap nature of a CDS.
According to Sengupta and Tam (2008)7Federal Reserve Bank of St. Louis: “The LIBOR-OIS Spread as a Summary Indicator,” Sengupta, R. & Tam, Y. M., 2008. (https://www.stlouisfed.org/ Accessed April 5, 2021), the LIBOR-OIS spread has been one of the most closely observed credit-based benchmarks for signaling distress in bank funding markets since the 2008 financial crisis. The LIBOR-OIS spread indicates the difference between an interest rate with some credit risk (LIBOR) and one that is generally risk-free (OIS). A widening of the spread suggests that the banking sector is under liquidity pressure. Before the financial crisis, little attention was paid to the spread, given that the difference in interest rates was insignificant at around .01 percent. During the peak of the crisis, the spread widened to as high as 3.65 percent.
The equivalent LIBOR-OIS spreads in each country are as follows: for the United States, US LIBOR-OIS comprises the US dollar 3-month LIBOR and the OIS priced on the Federal Reserve’s federal funds rate. For the United Kingdom, the GBP LIBOR-OIS rate is the sterling 3-month LIBOR and the OIS priced on the Bank of England’s (BoE’s) policy rate. For Canada, it is the 3-month CDOR-OIS spread with the OIS priced on the Bank of Canada’s (BoC’s) policy interest rate; CDOR stands for Canadian Dollar Offered Rate. In China, the comparable rate is the 3-month SHIBOR-OIS spread; SHIBOR corresponds to the Shanghai Interbank Offered Rate. The OIS is calculated using the People Bank of China’s (PBoC’s) policy rate. As for Europe, the 3-month EURIBOR-OIS is the Euro Interbank Offered Rate with the OIS calculated using the European Central Bank’s (ECB’s) rate. The Japanese equivalent TIBOR-OIS is the 3-month Tokyo Interbank Offered Rate. The OIS rate is priced on the policy rate set by the Bank of Japan (BoJ). Finally, the 3-month BBSW-OIS is the Australian comparable reference spread. The Bank Bill Swap Rate (BBSW) is the market interest rate; the OIS is priced from the Reserve Bank of Australia’s (RBA’s) monetary-policy rate.
Our research found that the US LIBOR-OIS is an important determinant of CDS spreads and, hence, the cost of wholesale funds for G-SIBs domiciled in Europe, Japan, Canada and Australia. However, this was found not to be the case in the UK or China
According to the Bank of England (2019)8Bank of England: “Has the link between wholesale bank funding costs and lending rates changed?” March 8, 2019. (https://www.bankofengland.co.uk/ Accessed April 4, 2021), this can be partly explained by the fact that UK banks rely less on unsecured debt-funding markets and more on alternative funding sources such as covered bonds and retail deposits. Moreover, the Bank of England reported that UK banks’ wholesale funding as a percentage of total liabilities had fallen from more than 40 percent in 2008 to less than 25 percent in 2017. Meanwhile, the insignificance of US LIBOR-OIS as a driver of wholesale-funding costs in China’s domestic banking sector can be attributed to China’s big four banks, which are categorized as G-SIBs, being mostly fund suppliers, reflecting their strong deposit franchises and more prudent growth strategies (Moody’s, 2016)9Moody’s Investor Services: “Moody’s: China’s banking system faces systemic risk from significantly higher dependence on wholesale funds”, August 29, 2016. (https://www.moodys.com/ Accessed April 5, 2021).
The implication is that the default risk of the US banking system has an important impact on funding costs of G-SIBs, which implies spillover effects from the US banking system to international financial markets. Furthermore, a large portion of bank funding costs of non-US G-SIBs do not depend on domestic default risk but rather are impacted by the default risk prevailing in the US, notwithstanding the fact that all G-SIBs have well-diversified wholesale-funding portfolios issued across multiple currencies. It can, therefore, be stated that non-US G-SIBs “import” US default risk through the wholesale-funding channel. This might be another source of contagion and spillover effect between US and foreign financial markets and may, in fact, lessen any impact of foreign monetary policy on domestic banking sectors; hence, it reveals a disconnect between interest rates charged on bank loans and monetary policy.
1 Bank for International Settlements: Basel Committee on Banking Supervision: “Basel III: the net stable funding ratio,” October 31, 2014. (https://www.bis.org/ Accessed April 5, 2021)
2 Journal of Banking and Finance: “What determines wholesale funding costs of the global systemically important banks?”, Cottrell, S., Yu, X., Delpachitra, S. & Ma, Y., Volume 132, Article Number 106197, Pages 1-17, 2021.
3 Financial Analysts Journal: “Credit swap valuation,” Darrell, D., Volume 55, Issue 1, Pages 73-87, 1999.
4 CFA Digest: “Valuing credit default swaps I: no counterparty default risk,” Hull, J. & White, A., Volume 31, Issue 2, Pages 91-92, 2001.
5 Journal of Financial Stability: “Solvency and wholesale funding cost interactions at UK banks,” Dent, K., Hoke, S.H. & Panagiotopoulos, A., February 2021.
6 The Review of Financial Studies: “On the relation between the credit spread puzzle and the equity premium puzzle,” Chen, L., Collin-Dufresne, P. & Goldstein, R. S., Volume 22, Issue 9, Pages 3367-3409, September 2009.
7 Federal Reserve Bank of St. Louis: “The LIBOR-OIS Spread as a Summary Indicator,” Sengupta, R. & Tam, Y. M., 2008.(https://www.stlouisfed.org/ Accessed April 5, 2021)
8 Bank of England: “Has the link between wholesale bank funding costs and lending rates changed?” March 8, 2019.(https://www.bankofengland.co.uk/ Accessed April 4, 2021)
9 Moody’s Investor Services: “Moody’s: China’s banking system faces systemic risk from significantly higher dependence on wholesale funds”, August 29, 2016. (https://www.moodys.com/ Accessed April 5, 2021)