FHLBInsider

Funding prime-based assets with LIBOR appears to combine the elusive characteristics of lower risk and higher reward

By James Eibel, consulting manager, assistant vice president

The term LIBOR has cropped up frequently in recent years. With brokers promoting securities tied to LIBOR, the Federal Home Loan Bank of Indianapolis (FHLBI) offering a variety of LIBOR-based adjustable advances, and loan customers inquiring about loans tied to LIBOR, the time is right to get a handle on LIBOR.

LIBOR, an acronym for the London interbank offered rate, is the rate at which major London banks lend U.S. dollar deposits (a.k.a. Eurodollar deposits) of various maturities. The most popular maturities are one, three, and six months. The LIBOR market encompasses both daily rates and the Eurodollar futures market. Because of the market’s unparalleled size and liquidity, LIBOR-based advances are typically the most economical short term funding offered by the FHLBI. Historically, these advances have been priced at LIBOR plus or minus approximately 0.05%.

Other than LIBOR-based adjustable rate mortgages (ARMs) and floating rate collateralized mortgage obligations (CMOs), assets tied to the LIBOR index are relatively uncommon. For this reason, LIBOR-based advances are most often used to fund assets tied to other indices, such as the prime rate.

Funding Prime with LIBOR

Funding prime-based assets with one or three month LIBOR-based advances has become an increasingly popular strategy with FHLBI members. The graph below tracks the changes in the spread between the prime rate and three month LIBOR.

The volatility between the indices is primarily due to the prime rate’s idiosyncracies. While three month LIBOR responds quickly to changes in market conditions, prime does not. Large banks tend to set their prime rate with one eye on market conditions and the other on their income statements. Thus, the prime rate follows other interest rates in a fortuitous manner for lenders. When interest rates fall, prime lags. When interest rates rise, prime usually moves with the sensitivity of money market indices, such as fed funds. Over time, these prime rate characteristics have led some commercial borrowers to seek market-based alternatives for their borrowings. Thus, the prime rate’s position as the standard for pricing floating rate corporate debt has waned in recent years. Additionally, the pressure from corporate customers to adjust the prime rate frequently has decreased. The result has been a rather dramatic growth in the spread between prime and three month LIBOR and a corresponding reduction in spread volatility.

Between 1985 and 1990, the average spread between the prime rate and three month LIBOR was 1.53%. Between January 1991 and November 1995, the average spread grew by over 100 basis points to 2.61%. Since risk and reward are directly related, spread volatility would have been expected to increase during this period. But in fact, as the spread between prime and LIBOR widened, the volatility actually decreased. The spread has been 40% less volatile (as measured by standard deviation) since 1991. In other words, the strategy of funding prime-based assets with LIBOR-based advances appears to have brought together the elusive characteristics of lower risk and higher reward. Since January 1991, the prime rate asset/three month LIBOR advance strategy would have produced both higher and less volatile earnings than before.

Both reprice frequency and final maturity need to be considered when funding prime-based assets. LIBOR advances reprice either every one, three, or six months. Three month advances have been most popular since they are readily available and offer the most competitive pricing. However, if your institution has convictions regarding future interest rates, either one month or six month LIBOR may be a better choice. If interest rates fall, one month LIBOR advances may provide enough reprice sensitivity to maintain or even widen spreads. If interest rates rise, the slower repricing of either three month or six month LIBOR may allow spreads to widen.

Paying off LIBOR-based advances prior to maturity may result in a prepayment fee. If your institution is concerned with its ability to prepay advances, maturities as short as three months can be used. In addition, a series of advance maturities can be "laddered" to enhance flexibility. If deposit flows become strong or loan balances decrease, the strategy provides periodic opportunities to pay down the advance position. If your institution has a general need for short term funding, the advance’s maturity may be secondary to rate considerations. Under most circumstances, the best pricing for LIBOR advances will be for maturities of one year or less. However, longer term advances (up to five years) may provide the opportunity to lock in an attractive spread to LIBOR and reduce future advance pricing uncertainty.

For more information on LIBOR, call the Marketing Division on its new toll-free number– (800) 442-2568.

This article has been presented for educational purposes only.  The FHLBI is not a financial or investment advisor.   It is solely the reader's responsibility to evaluate the risk and merits of any funding strategy or business proposal.

Copyright 1996, Federal Home Loan Bank of Indianapolis