Letter to the FT: Libor is both high and low (“Some confusion over Libor levels”)

Julian D. A. Wiseman

Abstract: Letter published by the Financial Times on Tuesday 3^rd June 2008 entitled Some confusion over Libor levels, (the author’s suggested title having been “Libor is both high and low”).

Publication history: the FT, and here. Usual disclaimer and copyright terms apply.

The following letter was sent to the Financial Times on 1^st June 2008 with the title “Libor is both high and low”, and published on Tuesday 3^rd June 2008 under the title Some confusion over Libor levels (the FT’s editors having added only two small errors!).

There are two issues about Libor levels being wrong, and it appears that the FT sometimes confuses them.

1. Libor is high. Banks have become less willing to make unsecured term loans to each other. This might be because they doubt the solvency of other banks; it might be that they are hoarding money so as to be able to withstand a run; it might be a result of a higher cost of balance sheet usage; or it might be an overreaction or a fear of others’ overreaction. Whatever the reason, it isn’t the fault of the British Bankers’ Association. It is a feature of the money markets, not of the Libor fixings.

2. Libor is low. USD Libor has recently been slightly under-reporting the elevated cost of unsecured inter-bank term borrowing. One possible cause is that banks wish to be seen to be able to access funds cheaply: in a confidence business it is important to be believed to be trusted (FT, Doubts over Libor widen, 21 April 2008). But, against this hypothesis, late last year GBP Libor was being reported slightly high, and EUR Libor about fair. Whatever the cause it seems that all three are now a bit low, particularly USD. But fixing this problem — Libor being lower than the actual cost of unsecured funds — probably requires better policing by the BBA of the banks’ contributions.

There have been suggestions that markets should use a cost of overnight funds as the benchmark. Yes, traders can swap against compounded Fed Funds, compounded EONIA, compounded SONIA, or even compounded 1-day Libor: these instruments exist and are traded. But if a bank is lending money to a company for six months, the bank has tied up funds for half a year: the natural comparator is the bank’s cost of six-month money. That is, or at least is very close to, six-month Libor.

Julian D. A. Wiseman
New York, June 2008