UK bank strains intensify as key sterling spread hits four-year high

LONDON : Stress in the UK banking system has intensified since Britain’s vote to leave the European Union, with the premium banks charge to lend each other short-term sterling funds doubling to its highest level in four years.The Libor-OIS spread is a gauge of banks’ willingness to lend to each other and is perhaps the most fundamental barometer of the banking system’s health. Its widening comes amid a sudden darkening of the outlook for Britain’s economy.

Sterling, shares sensitive to the domestic UK economy and bank stocks have slumped, and the Bank of England stands ready to loosen monetary policy to counter what many economists say is a looming recession.

The BoE this week took steps to ensure British banks keep credit flowing through the economy, lowering the amount of capital banks must hold in reserve to potentially free up an extra 150 billion pounds for lending.

The benchmark three-month sterling Libor-OIS spread has widened to 33 basis points, its highest since August 2012, from around 17 basis points immediately before the June 23 referendum. For most of the past four years, it had held within a narrow range of 10-15 basis points.

This spread widening needs to be monitored closely for warnings of broader financial stress, something the BoE is aware of too, said Christopher Vecchio, currency analyst at DailyFX.

“We’re not right at the edge yet but recession odds are creeping up and the flattening yield curve speaks to that.

“It’s still early in the game, but a flattening yield curve for banks is bad as it erodes their net interest margins. An environment of falling long-term yields is going to put a lot of pressure on financials,” he said.

Britain’s yield curve, the difference between two- and 10-year bond yields, has shrunk to 60 basis points, the flattest since October 2008. A flattening yield curve is widely seen as a harbinger of slower economic growth and lower interest rates.

The widening in the Libor-OIS spread stems largely from moves in the OIS, a gauge of the market’s view on where interest rates are headed. Traders have pushed the OIS rate down more than 20 basis points, effectively pricing in a Bank of England rate cut.

The three-month OIS is now a record low 19 basis points compared to more than 40 bps before the referendum, signifying a quarter point rate cut from the BoE in the coming weeks is now fully discounted. The three-month sterling Libor rate has fallen around 6 basis points to 52 bps.

“The three-month Libor-OIS spread is pushing out to the widest levels since summer 2012 and should continue to support flight to quality trades,” said Chris Turner, head of currency strategy at ING.

Government bonds have surged since the referendum, in Britain and around the world. The benchmark 10-year UK gilt yield fell to a record low of 0.72 percent on Wednesday, almost half its level on June 23.

Britain’s financial stocks have broadly fallen 16 percent since the Brexit vote, with shares in Barclays losing as much as a third of their value and state-owned Royal Bank of Scotland down as much as 40 percent.

The drop comes amid concerns about their exposure to the UK’s commercial property sector, where five funds have frozen redemptions this week.

While the Libor-OIS spread has doubled in size since the referendum, its nominal level remains much lower than those seen during the global financial crisis when it topped 300 basis points in November 2008.