Fall in LIBOR Bodes Well For Global Economy

Posted by: Mark Scott on October 20

After central bankers and policy-makers took unprecedented steps to shore up global financial markets, the economic support for the world’s banks — estimated at roughly $3.3 trillion — is starting to pay off. On Oct. 20, the London Interbank Offered Rate (LIBOR), the rate banks charge each other to borrow money, fell the most in almost nine months to 4.06%. The overnight rate for dollars also dropped to 1.51% - the lowest level since August, 2004.

While this might sound very technical, the fact interbank interest rates are falling is a sign financial institutions now are more willing to lend money, including to hard-hit homeowners and small businesses. It’s also a signal that attempts by central bankers to unfreeze the capital markets — and consequently boost the lagging global economy — are beginning to work. Here’s why.

When the credit crunch first hit, banks worldwide stopped loaning money to each other on fears that fellow institutions would post multi-billion write downs related to toxic subprime assets. In particular, they decided to hoard cash, preferring to sit on their reserves instead of taking the risk that loans to other banks would be sapped away by subprime losses.

That perceived risk sent the LIBOR rate through the roof, as well as practically freezing large areas of the capital markets. A sky-rocketing LIBOR doesn't just hurt banks. An estimated $150 trillion worth of financial products worldwide, for example, use it as a benchmark. Without new sources of cash to tap, banks and, more importantly, large sections of the economy couldn't borrow money, which consequently has led to the declining GDP growth we've seen so far this year.

The falling LIBOR rate means the restriction on credit could be coming to an end. Central bankers worldwide have announced guarantees to protect new lending, as well as bending over backwards to increase interbank market liquidity. That has included everything from offering almost unlimited access to Euros and Dollars to waiving or reducing the fees banks pay to borrow money from central banks.

Although controversial, these efforts seem to be giving financial institutions renewed confidence to lend to each other. Sure, further write downs may be on the cards, but many of these losses now are underwritten by governments. If banks feel confident to loan money again, the theory goes that the capital markets should reopen, and interest rates for broader lending -- to home-owners and small businesses, for example -- also should begin to fall.

That's why the Oct. 20 drop in the LIBOR is a welcomed signed. The global economy is by no means out of the woods, but if banks regain confidence to lend money, it should help soften the tough times ahead.