Market Insights

How Rising Interest Rates Affect Our Economy

Gold Alliance disclaimer

When banks borrow money from each other, the borrowing bank needs to pay interest to the lending bank. Most banks across the world use a set of daily average interest rates as a benchmark, the ICE LIBOR (International Exchange London Interbank Offered Rate). These interest rates are used by financial institutions as base interest rates and affect anyone from mortgage holders, small business owners, large corporations, and holders of student loans.

LIBOR consists of daily average interest rates for the US dollar, the euro, the British pound, the Japanese yen, and the Swiss franc for seven lending periods (from overnight to 12 months). The International Exchange (ICE) Benchmark Administration governs the 35 interest rates, which they calculate daily based on their surveying of participating banks (typically 11 to 18 large international banks).

The importance of LIBOR

LIBOR is one of the most significant numbers in the global financial world and is used by financial institutions, banks, and credit companies to set their interest rates. Currently, the value of financial contracts that are tied to the LIBOR benchmark is close to $300 trillion, and this number doesn’t even account for consumer loans and adjustable-rate home mortgages. LIBOR is also commonly used as the base rate for corporate funding, future contracts, and interest rate swaps.

Part of its popularity is due to the fact that LIBOR represents the lowest borrowing rate used among banks and financial institutions. Other rates are based on the LIBOR, often expressed as “LIBOR + X bps” (bps stands for base points; X is the premium added to LIBOR). In other words, when LIBOR changes, it affects interest rates and contracts that are based on LIBOR.

ICE LIBOR was known as BBA LIBOR until January 31, 2014. Its credibility was shaken when Barclays and other institutions came under investigation for submitting false borrowing rates and thereby manipulating the rate. Governance was transferred from the British Bankers’ Association to the ICE Benchmark Administration, and its credibility was restored.

Profits tied to LIBOR developments

A decade ago, a key short-term interest rate in the LIBOR set experienced a sudden hike, which signaled a crisis that nearly broke the US banking system. However, this year, the banking industry’s bottom line could benefit in the billions from a similar surge. Based on data disclosed by US banks, the largest US lenders might each make $1 billion or more in pretax profit—their borrowers who take out loans based on LIBOR must pay more when LIBOR increases, while the banks’ own cost of credit at this time, remains mostly stable (most of their own loans today are taken from their customer’s savings accounts and so, they are not based on LIBOR rates).

Potential pretax benefit                As % of profit

Citigroup                            $1.8B                                   7.8%

JPMorgan                           $1.5B                                   4.0%

Wells Fargo                       $1.0B                                   3.7%

Source: Company filings, Bloomberg calculations

According to Fred Cannon, head of research at Keefe, Bruyette & Woods, the short-term interest rate “was the sign [during the 2008 crisis] capital markets were frozen. Now, there’s all this liquidity, so they don’t need to borrow in the Eurodollar market [where rates are based on LIBOR].”

Banks aren’t as dependent on the short-term overseas markets as they were 10 years ago, so they’re using deposits to fund much of their operations. These customers are paid interest rates that remained on the low end (they rose around 0.1 percentage points) even after the three rate hikes (a total of 0.75 percentage points) in 2017 by the Federal Reserve.

Some of the benefit could be eaten up by higher rates banks will have to pay on long-term debt that is hedged using LIBOR-based swaps, but the banks aren’t disclosing how much debt they have hedged.

Most banks either don’t reveal how much of their lending is based on variable rates, or they don’t disclose how much of that lending is indexed to LIBOR. If we look at the largest bank in the US, JPMorgan Chase & Co., their 2017 report reveals that $122 billion in wholesale loans were at variable rates. If we assume that all those loans are based on LIBOR, the bank would see an additional $1.45 billion in income due to the 1.19 percentage point increase in LIBOR over the past year. Likewise, Citigroup could see additional pretax income of $1.77 billion, and Wells Fargo & Co. might see an increase of over $1.02 billion.

LIBOR’s surge

Other short-term interest rates are seeing slower increases compared to LIBOR, partly due to the recent US tax reform, which removed US companies’ incentives to keep capital offshore to take advantage of lower taxes. When they bring cash back to the US, it swallows up the supply of dollars used for short-term lending in the Eurodollar market, thus further increasing LIBOR. Due to the LIBOR surge, banks in the European and Japanese markets what are still relying on the Eurodollar markets will have to deal with higher borrowing