Small Banks Could Balk at Joining Private Lending Exchange Effort

Community banks will soon have a new way to lend to each other, though it is unclear how eager they might be to participate.

The Chicago Board Options Exchange announced plans last week to create an interbank lending market for small and midsize banks. The American Financial Exchange, or AFX, will allow banks to lend and borrow directly — a method similar to the federal funds market, absent brokers or intermediaries.

The AFX, a partnership between the Chicago Board Options Exchange and Environmental Financial Products, is designed to offer a new liquidity option for the industry's smallest players. But it will likely be an uphill battle to convince bankers of the market's potential upside, several industry experts said.

"It's just not clear to me what the problem is" with the existing market, said Robert Chirinko, a finance professor at the University of Illinois at Chicago. "The federal funds market exists … and banks of all sizes participate in that."

The timing of the exchange's launch is notable, given lingering uncertainty over a possible rise in interest rates. The Federal Reserve is set to make an announcement on rates Thursday, and predictions about a short-term rate hike are mixed.

"There's just so much uncertainty," said Lamont Black, a finance professor at DePaul University in Chicago, discussing broader market trends.

Richard Sandor, an economist and head of Environmental Financial Products, said he believes the timing is right to get a foothold in an interbank loan market that has "gone quiescent" since the recession. "This is a propitious moment to really launch something that will help banks with their asset management," he added during a recent conference call.

Weekly interbank lending volume has plunged in recent years, totaling $62 billion on Sept. 2, according to Fed data. Volume peaked at $492 billion in September 2008 and was as high as $191 billion in December 2010.

The exchange's founders plan to announce an official opening date by the end of this month. It will initially target roughly 1,700 banks with $500 million to $125 billion in assets.

"They're the ones that finance the Caterpillar tractors, housing and lots of other industrial products," Sandor said.

Most bankers contacted by American Banker declined to discuss the program, with some saying it was too premature to comment.

The exchange's appeal is tied to how the short-term lending market has changed since the financial crisis, said Bill Sirakos, head of capital markets at Cullen/Frost Bankers in San Antonio. Sirakos, who oversees the $28 billion-asset company's Fed funds desk, was involved in the exchange's design.

"Nobody was extending credit," Sirakos said, noting that he routinely had banks cut off during the crisis as Frost bulked up its own reserves. When the Fed began paying 25 basis points on excess reserves, Frost put its extra cash in an excess balance account. The company has yet to withdraw any of the funds, he said.

"The system is so flooded with reserves," he said.

While interbank lending volume remains low, the AFX could have an immediate appeal to banks with strong lending growth, Sirakos said. It could also attract small banks looking for a cheaper way to participate in the interbank market.

The AFX will be a self-regulated market, Edward Tilly, the Chicago Board Options Exchange's chief executive, said during a conference call, adding that the exchange will operate outside of the purview of the Securities and Exchange Commission and the Commodity Futures Trading Commission.

The Chicago Board Options Exchange will provide "electronic surveillance" to ensure that participants adhere to its rulebook, Tilly said.

The AFX will develop a new interest rate benchmark. The rate — Ameribor — will be determined by weekly auctions, which will begin in the fourth quarter. The benchmark could provide an alternativefor Libor, which has attracted widespread criticism after the 2012 rate-fixing scandal, Sirakos said.

"If you look at Libor, that's what it was supposed to be, until all of that hanky-panky got started," Sirakos said.

The new benchmark could create challenges for participating banks. It could create the potential for interest rate risk, or it could be intimidating for bankers who aren't interested in changing the way they do business, Black said.

"The question is how suspicious are smaller banks of Libor and the broader interbank market?" Black said. "How much are they willing to pay for a greater sense of comfort?"

Still, AFX executives sound optimistic. Plans are in place to create futures contracts on the exchange — similar to how Chicago Board Options Exchange developed the VIX market. In the meantime, bankers can expect to hear more about the exchange in coming months at events ranging from annual conventions to university lectures.

"We hope … to create benchmarks that are reliable and that are determined by the forces of supply and demand," Sandor said. "Somewhere in this world that we're living in, there will be some bank that will use these tools for asset liability management."