LIBOR - Is It Reliable & What Does It Say About the Current Financial Crisis?

A disturbing article in the WSJ last week suggested that the London inter-bank offered rate (Libor) may be less than fully reliable because some troubled banks may not be reporting the high interest rates they must pay to secure loans from other banks.  Libor is calculated daily on the basis of information reported from banks worldwide.  Troubled banks might have been reporting that they are paying a lower interest rate than they actually are because they don't want to 'fess up that their financial condition is so bad that they must pay an extremely high rate to borrow funds from other banks.

Libor is the base rate for calculating the interest on all sorts of loans, so if Libor is reported to be artificially low, then borrowers whose loans bear interest at Libor plus a specified percentage rate will be paying an artificially low rate.  That would be good for borrowers in the short run, but if there's a readjustment of Libor those borrowers could get hit with a sudden increase and the economy would suffer commensurately.  In addition, if Libor is artificially low, it misrepresents the severity of the financial crisis because it hides the fact that, in actuality, more banks are having to pay a substantial risk premium because of their troubled condition than we can see reflected in Libor.

Link to April 16, 2008, Wall Street Journal Page 1 Article, "Bankers Cast Doubt on Key Rate Amid Crisis" by Carrick Mollenkamp:  http://online.wsj.com/article/SB120831164167818299.html?mod=todays_us_page_one

In response to concerns about Libor, the British Bankers' Association (BBA) which oversees Libor "fast-tracked" an investigation into Libor accuracy. 

(ag) April 22, 2008, in Economy