BBA LIBOR: markets recover, worries persist

This morning, UK markets led a recovery after suffering heavy losses last week. However, BBA LIBOR rates are at historically high levels, after spiking sharply on Thursday and Friday. BBA LIBOR is a measure of the rate at which large banks will lend to each other in the London market. It is set daily, and shows the level of risk that financiers perceive.

Usually, Overnight BBA Sterling LIBOR rates will set just above the base rate - as decided each month by the Bank of England’s Monetary Policy Committee (currently 5.75 per cent). However, over the last few days it has risen to 0.75 per cent above the base rate (i.e. 6.50 per cent). The rates have not been as volatile, or as far above the base rate, since the Enron scandal in December 2001.

Overnight BBA LIBOR rates act as a barometer of risk in the financial markets. If the rates are significantly above the interest rates as set by the central bank, or government, it indicates that lenders are more worried about defaults on loans. Right now, rates are high due to the knock-on effects of US sub-prime mortgage worries.

Risk is a fundamental part of all financial transactions, and banks have developed sophisticated methods of assessing the risks of any deal. These are measured against the potential rewards and investment decisions are taken based on a view about whether the expected reward outweighs the risks.

In the US, many mortgages have been offered to people with poor credit histories. These so called “sub prime” loans are much more expensive than the average mortgage, to reflect the higher risk that the home-owner may default. The companies that lent the money have bundled these mortgages with other less risky mortgages, and sold them on to third parties. The worries that have recently arisen globally stem from the fact that financial institutions have bought packages of these, and are now unsure of their real value.

In this climate of uncertainty, the traditional means of assessing risk do not always work, and so banks, worried about the potential of losing money are unwilling to loan each other the money necessary to keep the wheels of commerce turning. This is the “credit crunch” that has been reported recently. In order to keep the global financial system running, central banks have had to step in and take on the role that is normally played by banks.

The recovery seen in stock markets today, indicate that banks fears of a crisis have eased, but the continuing high BBA LIBOR rates show that worries over risks persist.