What is LIBOR anyway? And What Is The Scary Message It Is Sending?

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 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 dinner table conversation of anyone working outside of the finance sector but it has seemed to take on a new importance as evidence 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 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 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 tern 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 a $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 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.