London Interbank Offered Rate (Libor) Controversy (June 2008)
Presently, there are two issues regarding the London Interbank Offered Rate (LIBOR). First, dollar Libor quotes are considered too high compared to the federal funds rate. Second, elevated Libor quotes are considered too low compared to other market-based interest rates.
British Bankers’ Association (BBA) Reaction (bba.org.uk)
The British Bankers’ Association (BBA) reviewed the situation and decided to alter the process for setting Libor. Possibly by fall 2008, the British Bankers’ Association will increase the number of banks that contribute the rates that comprise the London interbank rates. Using more contributor banks would give a more accurate average rate. Also, the British Bankers’ Association plans to increase the scrutiny of the contributed rates to ensure their validity. Changing Libor bank rates in any way is a challenge, legally and financially. Hundreds of trillions of dollars in financial contracts around the world depend on the Libor benchmark.
Libor Federal Funds Spread
Regarding the first issue, the federal funds rate is currently at 2% and the short-term dollar Libor rate is significantly higher. Actual Libor bank rates fluctuate and differ by maturity, but the overnight dollar Libor rate was recently at 2.48%. US banks can raise dollar funds from the US Federal Reserve. European banks cannot. This implies that US banks can raise dollar funds more cheaply than European banks. Dollar Libor is calculated using rates contributed by 3 US banks and 13 European banks. Because there are more European contributor banks than US contributor banks, the dollar Libor rates are skewed to the higher European rates. The BBA is considering publishing a separate index to represent dollar Libor quotes for European banks.
Validity of Libor
Recent rises in Libor lagged behind rises in other market-based interest rates. This raised suspicion regarding the validity of Libor. Some suspect contributor panel banks were underreporting their borrowing costs to avoid looking desperate for cash.
Contributor panel banks submit borrowing rates to the BBA each weekday. Some analysts suspect that contributor banks are submitting rates lower than the true borrowing rates. Banks may be reluctant to reveal that they are paying higher borrowing rates, which might indicate less creditworthiness. Lower than expected Libor rates could be evidence that some banks are submitting lower than actual borrowing rates. The financial markets expect the US Federal Reserve to raise its key interest rate later this year. This is influencing rises in short-term treasury yields and money market borrowing rates. In this environment, Libor rates have not gone up as much as expected.
Today’s Libor Index
For the dollar Libor rate today and other Libor current rates, go to: bankrate.com.
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Libor versus Prime Rate
Annual Percentage Rate
Required Rate of Return
What are the ‘Twin Deficits’?