Posts Tagged ‘foreign currency’

Libor and the Dollar

Thursday, March 5th, 2009

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Libor or the London Interbank Offered Rate, was introduced in early 1984 after it became apparent that an increasing number of banks were trading actively in a variety of relatively new market tools. The British Bankers’ Association (BBA) noted that these new tools notably interest rate swaps, foreign currency options and forward rate agreements, brought in more business and greater intensity to the London Interbank Market. However they were also worried that future growth would be hindered unless there was a standard introduced.

Hence, Libor was introduced as a standard and would become the British Bankers Association’s yardstick for interest swap rates.  This standard also incorporated the fixing of BBA interest settlement rates which became a part of the overall package officially known as the BAIRS terms – the BBA standard for interest swap rates. Ever since it was introduced, the Libor has been used as the official standard for calculating the rate of reference for the British Pound Sterling and other currencies including the US dollar.

Every weekday morning, as the clock ticks round to 11, a group of six people put together this world’s most important number. This number will later determine the day’s Libor rate or rather the rate banks charge when they lend each other money. To get a sense of the importance of Libor to the financial system you only have to look at the precautions that the team goes to make sure that the figure always gets published on time.

The group is equipped with an emergency evacuation office in Canary Wharf, London. They also have another permanently staffed office at a secret location outside London. Every team member also has a dedicated phone line in their home in case they are prevented from getting to the office, by an incident such as a terrorist attack. Nothing is allowed to come between Libor and the wider world.

However serious questions about the credibility of the Libor were raised, after a study released by the Wall Street Journal, revealed that banks may have downplayed borrowing costs they reported for LIBOR during the 2008 credit crisis. The immediate impact of this meant that banks could have created a false impression about their borrowing. By using the LIBOR to their advantage banks could create an impression that they could borrow from other financial institutions more cheaply than they could in reality. This meant that although the banks were suffering they appeared to be much healthier.

The BBA conducted an internal investigation, and announced that the LIBOR is definitely dependable and can be relied on even during the financial crisis. This was supported by other authorities including the Bank for International Settlements. It was also found that “Although the integrity of the U.S dollar LIBOR fixing process has been questioned by some market participants and the financial press, it appears that U.S. dollar LIBOR remains an accurate measure of a typical creditworthy bank’s marginal cost of unsecured U.S. dollar term funding”

As the U.S. government was set to propose more massive spending to help fight recession, the LIBOR for the U.S dollar increased even as the rate for Euros slipped to a record low. Analysts said that more government aid for the economy would keep dollar Libor rates on a mildly rising trend as the government would likely have to borrow more funds. Under such circumstances, banks do not want to lend out their spare liquidity because there is uncertainty - both about whether the bank will need the cash itself in coming months, and about the financial health of the borrowing bank.

As Libor measures the rates at which banks are prepared to lend to each other, it follows that it also determine the rate at which they are prepared to lend to their customers. It eventually goes on to set the rate of $360 trillion (£210 trillion) worth of financial products worldwide, ranging from mortgage rates to car loans. The big institutions are increasingly dependent on the central banks for cash and until this ends we’ll not see Libor rates falling.

So despite its daily fluctuations, it seems that the lack of trust between banks has rendered the market almost silent.But with the eyes of politicians, bankers and customers fixed on the daily Libor numbers, it seems unlikely that the attention on this world’s most important number will disappear.