Bankers' trust

"Why have banks been paying so much in the interbank market?SINCE last August, some of the world's most powerful central bankers have battled with growing resourcefulness to restore the law of gravity to the market that banks use for short-term borrowing. As the credit crisis has deepened, the central banks have made more money available against a broader range of collateral for longer periods to a wider group of financial firms. By throwing money at the situation, they have aimed to lower the London Interbank-Offered Rate (LIBOR) that banks charge each other for anything up to three-month loans (it helps determine borrowing rates for firms and households, too). But the rate remains stubbornly high; it has jumped again recently on reports that the British Bankers Association, which sources quotes each day from a panel of banks, is investigating whether banks have been reporting lower rates than they are actually paying in order to appear healthier than they are.Before the crisis broke, typically banks would provide unsecured three-month loans to each other at rates that were barely higher than their cost of borrowing from the central bank. But last August, the gap between LIBOR and the overnight indexed swap (OIS) rate (a gauge of expected central-bank rates over the same period) widened sharply in Europe and America (see left-hand chart). At times, the gap was almost as wide as during the Y2K fears at the turn of the century. According to a recent paper* published by the Bank for International Settlements, the higher risk premium reflected in the rise of LIBOR over the OIS rate responds to several factors, particularly credit and liquidity risk. The first points to the bigger chance that a bank will go bust over a three-month period than overnight. As for liquidity, a three-month loan can less readily be exchanged for cash than an overnight one and lenders require a reward for that risk. ..." (2008-4-24)

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