Libor: A benchmark or a rate?
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Libor: A benchmark or a rate?

The belief that Libor is an actual rate at which banks lend substantial money to one another is a façade that the credit crunch has torn down with a vengeance.

Is the increased gap between Libor and overnight rates a Machiavellian scheme, where liquid banks are forcing up Libor to earn extra cash on products that are indexed against this measure of money market rates? Can the central banks do anything to stop banks hoarding cash and so close the gap? Are the money markets broken? The probable answer to all these questions is no.

Distrust and concern at the level of Libor is understandable. The gap between Libor and overnight rates remains nearer 100 basis points than the 10bp spread seen a year ago. But so what if Libor spreads are at historically wide levels? There are plenty of money market participants that say it doesn’t really matter to them and that they are just trading rates – as they always have.

Navel-gazing over Libor might seem slightly arcane but the problem is real. This measure of money market activity is embedded into the financial system. Some $350 trillion of products are indexed against it, according to the British Bankers’ Association.

Libor is a rate set by a small market with its own vested interests that drives pricing in a vast, far larger universe.

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