Unsecured interbank lending rates have shot up in the wake of the multiple financial shocks of the last fortnight.

In the US, banks can partially offset the impact of rising unsecured rates on their average cost of funds by increasing their borrowing from the Fed’s discount window (or "primary credit facility"). Cash is available for up to 90 days at an interest rate of 2.25% (a 25bp premium to the Fed funds target rate) versus today’s three-month dollar LIBOR fixing of 3.77%. While borrowing is secured, collateral rules are loose, with mortgages, corporate securities and asset-backed commercial paper eligible.

UK banks are at a disadvantage to their US counterparts because there is no equivalent Bank of England credit line. The Bank’s version of the discount window is its “standing lending facility”, which offers overnight funds at 1% above Bank rate against only the highest-quality collateral. The facility has remained unused throughout all of the last year’s financial calamities. The Bank has promised reform of its money market operating arrangements but it is unclear how the SLF will change.

The Bank’s alternative to the Fed’s generous discount window is the special liquidity scheme, under which banks can swap lower-quality collateral for newly-minted Treasury bills. These bills can then be used to obtain cheaper secured funds in the gilt repo market. However, banks must pay the Bank a fee equivalent to the spread between three-month LIBOR and the three-month gilt repo rate. The SLS improves liquidity but banks still end up paying LIBOR to raise funds. By contrast, the Fed’s lending both boosts liquidity and reduces average funding costs.

The Fed effectively creates money at the 2% Fed funds rate and lends it out via the discount window at 2.25%, earning a 25bp margin. The Bank of England is raking in much larger profits from the SLS, with the spread between three-month LIBOR and the three-month gilt repo rate ranging from 50bp to the current extreme 150bp since the scheme’s inception. Assuming average usage of £200 billion in the first year at a spread of 75bp, the Bank will earn £1.5 billion or £4 million a day.

The Bank argues that the current fee structure is necessary to avoid subsidising banks. However, this assumes LIBOR is a valid price determined in functioning markets by rational agents – clearly not the case at present.

Any bank using the SLS to obtain collateral and raise funds this week will lock in current high LIBOR borrowing costs for three months. Only those in severe difficulty are likely to accept such terms. By design, the scheme becomes more expensive precisely when banks need it most.

Two modest changes to address these deficiencies would be: 1) base the fee on the average LIBOR / gilt repo rate spread over the following three months rather than its starting level; and 2) set a maximum of 75bp (there is already a floor of 20bp).

Such modifications would probably have little impact on LIBOR itself but would partially relieve upward pressure on banks’ funding costs and, by extension, household and corporate borrowing rates.