Explainer What is Libor?
Libor stands for the London interbank offered rate and is the main setter of interest in the London wholesale money market. Unlike bank rate, which is set directly by the Bank of England, Libor rates are set by the demand and supply of money as banks lend to each other to balance their books on a daily basis.
Libor covers lending from overnight up to one year and is used to price all kinds of financial instruments such as loans and floating-rate mortgages. Instruments in several other currencies are also priced relative to Libor, such is the size of the London market.
The focus now is on the three-month Libor rate. This normally trades at a small premium of around 0.15% over where the market thinks the bank rate will be in three months’ time. So recently it had been hovering at just over 6%, since bank rate was widely expected to be raised from 5.75% to 6%.
But two weeks ago the rate shot up to 6.6% and has stayed around that level, hitting an eight-and-a-half year high of 6.7% yesterday. This reflected a reluctance by banks to lend to each other for fear that the counterparty may have problems related to the US sub-prime mortgage crisis and not be able to pay the money back.
The same thing happened in the eurozone money market yesterday, with the euro Libor three-month rate widening to its highest since May 2001 at 4.74%, compared with the European Central Bank’s base rate of 4%.
“The size of the potential problems for the banking sector both in Europe and in the US is still very uncertain and might be very large and this is what is keeping interbank markets and money markets dislocated,” said Marco Annunziata, chief economist at UniCredit
Matthew Cairns, at Moody’s research arm Economy.com, agreed: “Banks are holding back purely because there is a serious unknown here which has never existed before. I don’t think money markets are convinced we’ve hit the worst of what is to come.” Ashley Seager
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