The Real Issues: Economics
What
is LIBOR anyway, and what is the scary message it is sending?
By Michael Mohr, Oct. 27th, 2008
I attended a seminar last week aimed at
educating small business owners about how to access debt in
today’s
market. One of the speakers at this meeting was a regional manager
for a local bank in charge of overseeing commercial loans for
several of the industrial sectors of New York City. After you read
the following article, you will hopefully understand why I gasped when
the banker responded “I don’t really
know” when asked “Can
you please explain what LIBOR is, and how it is shifting your
bank’s
business decisions for commercial loans.” I will do my part
to
educate everyone on what this term means and to explain why this banker
REALLY should be paying attention to it.
LIBOR stands for London Interbank
Offered Rate. It is the interest rate charged when large financial
institutions lend to each other. The rate is fixed daily by the
British Banker’s Association through a survey of major
banking
institutions. This metric is usually not part of the dinner table
conversation of anyone working outside of the finance sector, but it
has seemed to take on a new importance as evidenced in the above story
where a small business owner was suddenly concerned about it. Since
it is set by a daily survey, it has come to reflect a market-driven
benchmark for the fear banks have when lending to each other, and, as
such, is an important new economic indicator.
My interest in this marker
started
early last spring as I started to see an uptrend at work in bank
commitment letters using LIBOR for commercial loans. Simultaneously
it seemed to be thrust into mainstream media. Traditionally
commercial (and home) loans use the Wall Street Prime
Rate, which is closely tied to the Federal
Funds Rate. As Mr. Kirchofer
accurately points out in
his
article outlining the financial
crisis, the Federal
Funds Rate is a fundamental tool the Federal Reserve uses to execute
monetary policy in the U.S. But by the spring of 2008, it seemed that
the Federal Reserve was loosing its grip on making effective changes
in the market. As pointed out in a May New York Times article by
Julia
Werdigier. “…when
the credit market seized up last
August, many banks, concerned about their own financial positions,
were no longer willing to lend money to one another. As a result,
Libor shot up, even as central banks like the Federal Reserve tried
to drive borrowing costs lower.” The disconnect between the
Funds
Rate and LIBOR adds a new dimension to this crisis.
This frightening trend has
emerged
because LIBOR, in this financial climate, reflects a bank’s
real
risk. Banks rely on each other to meet day-to-day cash calls with
short term lending (1-3months), and the interest rate for this lending
is again the LIBOR. LIBOR on the rise is an indication that banks are
hording their cash to meet only their cash calls and that they see
lending to
other Banks as highly risky. Then, just as a classic bank run will
work, this perception of risk to lend to other banks is a
self-fulfilling prophecy. A bank will not lend to another for fear of
the
lendee becoming insolvent, but that in turn makes the lendee
insolvent.
During this past summer, as
100-year
old financial institutions met their demise, this problem became much
worse. The LIBOR stayed almost unchanged after the Fed and central
banks around the world coordinated a global cut in interest rates.
Bloomberg news reported in an article
today that the Federal Reserve is
considering cutting
the overnight rate to 0%! The Fed’s mechanism seems to be
loosing
its effectiveness with each passing day.
Compounding this problem is
a new fear
of turning to the Fed as a lender of last resort. This can best be
seen through AIG, who after receiving an $85
billion loan in September saw their
already embattled
stock value plummet from about $22/share to about $2/share (as of the
time of writing this article AIG is still around $1.40/share). The
point being that the Federal Reserve is becoming a non-option, a
white flag of distress that banks cannot afford to use. As a result,
the only way to solve liquidity issues is now out of the hands of the
Federal Reserve’s ancient tool belt. LIBOR is the new metric
for
this crisis, at least for the time being.
There is light however at the end of this tunnel. Central banks around the world have seemed to realize the importance of these inter-bank loans and have started to guarantee shot term loans between banks. As a result, the LIBOR rate has seemed to have stopped its upward acceleration in the last week. It is a dim but hopeful light that there is an easing of the liquidity crisis. When things go back to “normal” the funds rate will probably come back into play, but for now everyone should be keeping their eye on LIBOR.
For more information, see The Economist's article from October 23rd.