The Impact of LIBOR Linked Borrowing to Cover Venture Bank Investment Loans Creates a New Systemic Risk

TL;DR

This paper examines how using LIBOR-linked borrowing for venture bank investments under regulatory coverage requirements introduces systemic risk by limiting profitability and destabilizing banks, especially under adverse market conditions.

Contribution

It models a scenario where LIBOR-linked borrowing and minimal default insurance create new systemic risks in venture banking.

Findings

Venture banks survive with favorable returns at low interest rates and high returns.

Profitability is limited by LIBOR-linked borrowing, reducing bank stability.

Systemic risk increases as returns fall or interest rates rise, risking bank failure.

Abstract

A scenario in which regulators take the drastic step of requiring coverage of all venture bank investment loans using interbank borrowed funds is considered. In this scenario, a minimal amount of default insurance is used, such that Tier 1 and 2 capital requirements are still met. To do this, the default insurance percentage on all investment loans is cut to 3.88%, although the minimum is 2.88%. Results: For a portfolio of 1.31X (ten year total conventional return) or better, at interest rates of 2% or better, the venture bank survives and can have excellent returns. For a portfolio of 1.5X (ten year total conventional return) the bank can have extraordinary returns below 1.5% interest and survive up to 3%. interest. However, if returns fall, or interest rates rise, then venture banks go underwater quite rapidly. Conclusion: Using LIBOR funds limits profitability, and damages stability of the bank, with no visible benefit to any party, thus creating a new systemic risk to the banking system.