Before we fund the $700 billion bailout...
Questions on Reliability of Interest Rate Rise Amid Central Banks' Liquidity Push
The accuracy of a widely used interest rate, seen as critical to judging the health of the financial markets at a precarious time, is coming under question for the second time this year.
Doubts about the London interbank offered rate, or Libor, center on whether banks are understating what it costs them to borrow dollars in stressed financial markets. Libor's reliability became an issue again this week when banks paid higher interest rates to borrow using collateral than they did for unsecured loans.
Those questions come as central banks inject liquidity into the market to restore the confidence of banks that have been reluctant to lend to one another. Other lending markets, including commercial paper, which are short-term IOUs issued by companies, have also struggled, potentially causing a credit crunch to spread throughout the economy.
Libor is supposed to reflect average bank-borrowing costs. Overseen by the British Bankers' Association in London, the rate serves as a benchmark for the borrowing costs of homeowners and companies. During the credit crisis, it has provided a gauge for whether banks trust one another enough to lend money. Last week, Libor rates surged in a sign that banks were having trouble borrowing money amid the problems at American International Group Inc. and Lehman Brothers Holdings Inc.
Concerns about Libor's accuracy emerged out of the rates being paid in another market used by banks to get cash. The Federal Reserve's term auction facility, one of numerous efforts the Fed has been using to fight the credit crunch, allows banks to borrow, but they must put up collateral.
Because of that, banks should be able to pay a lower interest rate than they do when they borrow from each other because those loans are unsecured. It is the same reason why rates for a mortgage, which is secured by a house, are lower than those for credit cards, where the borrower doesn't put up any collateral. In other words, the rate for the Fed auction should be lower than Libor.
But on Monday, the rate for the 28-day Fed facility was 3.75%, which was much higher than Libor. On Monday, the one-month dollar Libor rate was 3.19% while Tuesday's rate was 3.21%.
The Fed facility should be lower, said Scott Peng, a Citigroup Inc. U.S. rate strategist. The "market needs some accurate transaction-based measure of interbank lending."
Earlier this year, Libor appeared to be sending false signals. Banks complained to the BBA that rival banks might not be reporting their true borrowing costs because they didn't want to admit that others were treating them as if they had troubles. That led to a BBA review and the pledge that the rates banks contribute would be better policed. Every morning, 16 banks submit borrowing rates in a process that produces Libor rates at lunchtime in London.
Lesley McLeod, a BBA spokeswoman, said the BBA stands by the Libor. "Libor is accurate," she said. "It is constantly monitored and currently reflects the extreme market volatility present in these unprecedented circumstances."
By: Carrick Mollenkamp
Wall Street Journal; September 24, 2008
