Tarnished Libor

Now that the market is turning, some of the structures onto which everything else is built are starting to come into question.

One of these, and one of the most important, is Libor – the London Interbank Offer Rate. This is the rate of interest set by banks, and has developed as the benchmark rate over which most commercial lending is referenced against.

However, one consequence of the credit crunch is that banks do not like lending to each other, and there are suggestions that the Libor rate is now not representative of the actual interbank rate.

In other words, banks might be lying to the data providers about the actual level of Libor.

This is something that I have been hearing from my own market sources, who say that very few banks are funding at Libor at the moment, even the ones that 'should' be (ie the 16 banks that provide the reference rate).

This might just be a blip (and it probably is) but it is having real effects on commercial lending.

Amongst other things, it is driving up investment grade syndicated loan pricing.

If a big corporate such as Reed Elsevier (which has just borrowed a substantial amount in the syndicated loan market) wants to borrow money from banks, the interest rate Libor+0.5% (L+50bp in the jargon) no longer offers many banks 50bp more than the rate they are funding at. Instead, it is now L+35bp, L+25bp or whatever, as even big banks are funding at a spread over Libor.

This means investment grade pricing is having to rise, both against the now tarnished reference rate, and overall.

Bankers will be hoping that as the credit crunch eases reality will re-enter the Libor rates, which may also lead to lower headline interest rates for commercial lending.

But then again it might not, and banks (and borrowers) might have to accept higher rates of Libor, or try to find an alternative, one that they all agree upon.

But I would imagine that banks would be very reluctant to find a new reference - for one thing, the doubt in the current reference is not because a better alternative naturally suggests itself.

Edited to add: Yves Smith makes the extremely valid point that this adds even greater uncertainty into a market that is not exactly short of things to feel uncertain about.