Why you care about LIBOR
The new favorite act amongst financial “journalists” has been to provide daily updates on the state of the overnight and 3-month LIBOR. Today, was particularly interesting as the overnight LIBOR finally declined below the Fed Funds rate to 1.28% and the 3-month LIBOR continued its precipitous decline from a high of 4.80% a week and a half ago to 3.83%.
Many people sitting at home are probably wondering why LIBOR has suddenly become so important and why no one was paying attention to it months ago. LIBOR is an acronym for the London Interbank Offered Rate. This is the interest rate at which banks lend to each other. It is compiled by the British Bankers Association which is a group of over 200 banks representing 60 different countries. The LIBOR rate that is typically reported is the rate that these banks use for dollar-denominated securities. As every bank in America is “dollar-denominated,” the LIBOR rate is essentially the benchmark rate at which banks are lending to each other here in the States.
Because many banks operate on signficant leverage, day-to-day functionality is must be covered through short-term loans between banks that have cash and banks that don’t. A worrying result of the credit crunch was the fact that banks began to distrust one another and became reluctant to lend money to each other. At its peak, overnight lending rates reached as high as 7% and the 3-month LIBOR (the rate for 3-month loans) reached as high as 4.8% despite the fact that the Fed continued to cut its Fed Funds rate to a scant 1.50%.
The Federal Reserve acts as a lender of last resort and provides overnight loans to banks which need them but maybe can’t get them from other banks. The Fed does this by offering loans through the discount window at .25% above the Fed Funds rate which it publicly announces. This means that with a Fed Funds rate of 1.50%, any bank could lend overnight from the Fed at 1.75%. Yet, despite this easy access to money, banks around the world were still charging each other in excess of 7% to make overnight loans. Essentially, this meant no loans were being made.
Without the flow of overnight and other short-term loans, banks without a sufficient capital base (cash) were basically counting the days until they would no longer be able to fund operations. Furthermore, if banks can’t lend to themselves, they sure as hell aren’t lending to businesses that may also need capital to purchase inventory and pay employees. This is why so much drastic action was taken by the US Government and other International central banks in the last two weeks. The longer the credit freeze in financial sector went on, the more likely other businesses (banks and non-banks alike) would collapse. And, that is why you should care about LIBOR.
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