The LIBOR Disconnection
Posted by David Gaffen
In the last several months, the U.S. Federal Reserve has promulgated various lending facilities with long, complicated names. There are many missions, but one in particular: getting major banks comfortable with lending to each other on a short-term basis at levels that aren’t exorbitant. In short, doing what banks, until August of last year, did without batting an eyelash.
So far, it hasn’t worked, and it’s become a source of frustration to banking executives, as Citigroup Inc. CFO Gary Crittenden noted on his company’s earnings conference call Wednesday.
“Obviously there are a lot of people who are focused on what could happen to bring LIBOR down,” he told analysts. “We will take action, obviously, if it continues to be kind of disconnected, if the pricing and the cost of funds continue to be disconnected.”
The question is, where will the money come from? The short-term funding needs of banks have largely been satisfied in the overnight and short-term lending markets, where banks borrow from each other, using unsecured loans, paying the London interbank offered rate, or LIBOR, which generally is set a few hundredths of a percentage point above the U.S. Federal Reserve’s federal-funds target.
Right now, the best option for Citigroup and others is the Federal Reserve. Thanks to the various lending facilities the Fed has set up, banks have been working around their inability to borrow from each other (a self-serving cycle, in a way) by going to the Fed.
With the current fed-funds rate at 1.5%, a normal LIBOR rate would be in the range of 1.55% to 1.65%. But the spread between LIBOR and the funds rate started to widen out in August of 2007 and has not snapped back to its previous shape.
As of Thursday morning, overnight LIBOR was 1.94%, or 0.44 percentage point above the federal-funds rate. Wednesday, that rate was 2.14%, and it continues to fluctuate wildly due to the thin trading in that market.
Banks don’t have a lot of other options for short-term funding. Commercial paper rates are higher for banks than for similarly rated corporations, and it’s a less popular market for banks. “They don’t have a lot of good options, except for one biggie, and that’s the unlimited sources of funding from central banks,” says James Bianco of Bianco Research.
But using the central bank as a crutch is disruptive to the short-term markets. Banks can’t accurately portray overnight and short-term rates if little borrowing is happening, and that results in LIBOR being little more than a guess.
For example, three-month LIBOR was set at 4.50% Thursday. Normally the banks surveyed would have put it right around that level, but the difference between the highest and lowest bank was nearly a full percentage point, Mr. Bianco said.
“When they don’t deal with each other, these other markets cease to exist,” he said. “And we need a benchmark for short-term funding for everybody outside the banking system.”
