The Importance of the LIBOR

LIBOR is the acronym for London Interbank Offered Rate and this rate can vary from basis points in the tens to the multiple hundreds. The LIBOR is widely used as a financial benchmark for both consumer and business finances worldwide and is linked to the lending of over a hundred trillion dollars. (economistsviewtypepad.com) To put that in perspective, the U.S. economy produces around $14 trillion in value every year, making the LIBOR's influence very large.

LIBOR rates are set daily for 1 month, 3 month, 6 month and 1 year lending between United Kingdom banks. The reason LIBOR is important in regard to a credit crisis is because lending rates can affect the availability of capital in a financial system. The higher the LIBOR rate is, the greater the cost of borrowing funds for individual, real estate, equipment, individual or other loans becomes.

What happened to LIBOR during the credit crisis

When the most recent credit crisis began and the U.S. Federal Reserve Bank was lowering interest rates and making funds generally more accessible, the LIBOR continued to rise until October 2008, well into the credit crisis. (wsjprimerate.com) Essentially, this meant the British Bankers Association responsible for setting LIBOR rates were either unable to convince banks to lower rates or not fully cognizant of the implications high LIBOR has on financial markets. Unfortunately, the credit crisis was a big problem for the U.K. and the LIBOR did end up being lowered. In fact, the 1 month LIBOR rates dropped from over 3.8096% in October, 2008 to .3834 percent in January, 2009. (wsjprimerate.com)

The fourth quarter 2008 and 1st quarter 2009 drops in the LIBOR were due primarily to a recognition the credit crisis required liquidity to be alleviated. Dropping the 1, 3, 6 and 12 month LIBOR rates implied lower costs of financing new lending for banks. The reason LIBOR rates took so long to decline so long after the credit crisis started has to do with credit worthiness of banks. Since banks lend to each other with the risk of default, the risk of default rises during a credit crisis despite being a bank with good credit. Consequently, the default risk was built into the LIBOR rate until the credit crisis risk became higher resulting in a lower LIBOR.

Direct consequences of LIBOR and LIBOR Metrics

As a market indicator, a lower LIBOR indicates 1) acknowledgement of the magnitude of problem the credit crisis imposed on financial institutions and 2) the cost of borrowing money for financial institutions utilizing the LIBOR 3) measurement of perceived risk in the credit market and 4) assessment of progression and development within credit crisis. The causes of changes in LIBOR have been measured statistically by comparing the rate to other market lending rates. 

For example the TED spread is used to determine the difference between LIBOR and government securities yields of the same maturity. Other spreads used include the overnight interest swap rate for 30 day LIBOR, credit default swap rate to LIBOR spreads, and bank solvency risk to LIBOR spreads for measurement of credit and lending risk as a cause for LIBOR rates. (economistsviewtypepad.com) The course credit crises take is dependent on a wide range of factors both economic and financial.

A lower LIBOR has the effect of alleviating and spurring on economic and/or financial growth but is still only one of the variables in the equation of market and economic growth. Since LIBOR is not as connected to the government as the U.S. Reserve's Federal Funds Rate, the LIBOR is a more direct measurement of market conditions rather than Government linked response to financial market conditions. 

When LIBOR rates decline it may also be an indicator of where the financial markets are within a credit crisis. For example, since LIBOR reflects lending and default risk, a lowered LIBOR may indicate more creditworthiness between banks and a beginning to progressed resolution of the credit problems within the crisis. Moreover, a continually lowering LIBOR or bottoming of the LIBOR over time may also indicate the desire for financial growth combined with lower credit risk between banks.

Summary 

In summary, the LIBOR is an important banking-lending rate tied to a large amount of money worldwide. When credit and lending risk for banks rise, generally, so does LIBOR. However, when these risks become resolved, or are less important than the need for commercial growth, the LIBOR would decline. During the unresolved concerns of the credit crisis, LIBOR rose dramatically as commercial lending tied to the previous financial crisis devaluated. This happened even as the U.S. Federal Reserve has consistently lowered its lending rates. 

Evidently, the risks were still present throughout this period. It wasn't until the 4th quarter of 2008 and 1st quarter of 2009 that the LIBOR began to decline reflecting a possible resolution or bottoming of the credit problems and risks associated with the credit crisis. Nevertheless, in late January 2009, the three month LIBOR did experience an uptick indicating a possible continuation of credit risk.

Sources:

1. http://www.investopedia.com/terms/l/libor.asp
2. http://www.telegraph.co.uk/finance/economics/2815187/Liquidity-crisis-grows-as-Libor-rates-gap-hits-20-year-high.html
3. http://www.wsjprimerate.us/libor/libor_rates_history.htm
3.  http://tinyurl.com/6339trl (London Evening Standard)