In an earlier Market Insights story, under the subject of derivatives and interest rate swaps, I introduced the subject of the Libor (pronounced lie-bore). The variable-rate component of interest rate swaps is often tied to the Libor. Estimates put the total “notional” value of derivatives contracts that link to Libor at hundreds of trillions of dollars. Libor is the London inter-bank offered rate. It is used widely throughout the financial system and, therefore, more elaboration on its finer points is warranted.

The Libor system was developed in the 1980s. It is overseen by the British Bankers’ Association, although data is reported to Reuters Group PLC for distribution to financial institutions and the media. Libor rates are set each morning in London England based on information supplied by banks all over the world. They are the average interest rates (for varying terms) at which banks make short-term loans to each other. Libor rates are established for 15 different loan durations, from overnight to one year, and in 10 major currencies. Besides their use in interest rate swaps, they are used in calculating loan rates (i.e., based on a certain markup) on corporate loans, mortgages and even student loans.

One major impact of the financial crisis has been to raise borrowing costs. Banks have found it difficult to raise money by traditional means. Therefore, they have been turning to the interbank market to borrow short-term cash. But banks have been reluctant to lend to each other, forcing up Libor rates.

How will we know when the financial crisis is over? A key measure of the degree of uncertainty in financial markets has been the spread between the three-month Libor rate and U.S. three-month Treasury Bills, which are generally taken to be as secure as a debt instrument can get. The interest rate differential, Libor over Treasury Bills, is an inverse proxy for the financial health of banks.

The long-term average gap before the financial crisis began was miniscule, about 25 basis points. In recent days the Libor has climbed to a record high 6.88%. The 3-month Treasury Bill rate is under 2.00%. The international banking system is still well and truly mired in a credit squeeze. Quick and decisive action on the financial bailout package will be needed to clear the lending bottleneck.

Some of the background information for this report came from a Wall Street Journal article dated April 26, 2008.

Alex Carrick

Find Canadian construction-related economic articles in Canadian Construction Market News and in the Economic Outlook section of Daily Commercial News.

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