The Bankwatch

Tracking the consumer evolution of financial services

LIBOR and why it matters | risk that any bank could face a run on its deposits

There is a fascinating, though apparently esoteric debate going on in Banking circles. It is worth understanding the high level points though because it actually matters to bank employees, vendors, and bank customers.

Libor (London Interbank Offerred Rate) is set daily, and represents the rate that banks will lend money to each other on the money market. It is one means of managing liquidity for Banks. Lately this rate has been much higher than expected and than historic rates. The going assumption was that Banks were afraid to lend to each other since the credit crisis due to inadequate risk identification relative to ABCP based on sub prime US mortgages.

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Some observers blame this pattern on shortcomings in the way that Libor itself is calculated. However, behind the scenes, some investors are also starting to argue that it could be time to rethink what the Libor rate is telling the market.

Until now, bank analysts have assumed that the high cost of interbank
borrowing stemmed from a sense of mutual distrust. This would suggest
that, on two occasions in the past eight months, banks have been so
nervous of counterparty risk – the danger of one’s trading partners
failing to honour their financial commitments – that they did not wish
to extend funds to each other

The level of risk identification is getting closer to resolution relative to sub prime, yet libor remains steadfastly high. This is bringing anaysts to rethink the situation, and rather than replace libor as some suggest but observe and understand what the higher rates are telling us.

… … some observers are now thinking that the interbank, or money, market
has entered a new, third, phase, one that has less to do with
counterparty risk and everything to do with the risk that any
institution could face a run on its deposits or other short-term
funding.

Thus, the problem is not that banks are paranoid about
each other, or so the argument goes; instead, banks are paranoid about
their own funding state – not least because they have seen what a lack of liquidity did to Bear Stearns.

In simple terms … Banks are concerned about their own cash holding to protect against a good old fashioned run on the Bank. By holding on to cash, they are creating a scarcity in the market, hence higher libor.

An articulate summary of this thinking from head of the ECB, noting that one instrument validates the reduction of risk, yet libor remains high.

Jean-Claude Trichet, president of the European Central Bank, …. “That
would explain the simultaneous diminishing of credit risk as seen in
the [credit derivatives] market and the [elevated] spreads between
three-month money market and overnight swaps.”

Written by Colin Henderson

May 8, 2008 at 12:29

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