Libor rises on debt concerns

By Michael Mackenzie in New York and David Oakley in London
Published: May 16 2010 (Financial Times)

Concern about the exposure of European banks to the debts of weaker countries in the eurozone is stoking growing risk aversion in money markets and increasing the amounts banks charge to lend to each other.

The London inter-bank offer rate, or Libor, has risen in recent weeks to its highest level since last August, especially for dollars, which is significant because the rate has served as a leading gauge of stress during the financial crisis.

The rise in Libor – which affects consumers and companies because it is the reference rate for many floating rate loans and mortgages – has come even though central banks are in no rush to tighten monetary policy.

Analysts say Libor’s recent ascent reflects fears that the €750bn ($928bn) emergency funding facility agreed by the European Union and International Monetary Fund last week will fail to fully resolve the crisis in the eurozone.

The Bank of Japan became the first central bank to react to concerns over sovereign debt strains in Europe 10 days ago by adding overnight liquidity to help investors looking to switch out of euros and into dollars.

“Although stresses are not anywhere near those seen after Lehman Brothers collapsed in 2008, the fact money market rates are rising is a warning of potential problems and shows how nervous many people are in the market,” said Don Smith, economist at Icap.

Brokers expect three-month dollar Libor will rise to 0.46 per cent when banks open for business on Monday, up from Friday’s setting of 0.445 per cent and extending a rise from under 0.30 per cent since early April.

As Libor has risen, the quotes from the 16 contributing banks have diverged, indicating that some banks are seeing tougher funding conditions than others. Last Friday, HSBC provided a low quote of 0.38 per cent, while West LB contributed a high of 0.51 per cent.

Another indication of rising fear can be seen in the cross-currency swap market, which is more liquid than Libor. Demand for dollars through such swaps has not eased in the wake of the eurozone bail-out package revealed last week.

Before the crisis, traders paid an extra 60 basis points to swap euros for dollars for three months. That cost rose to 102bps before the bail-out plan was announced, dropped to 78bps earlier last week, but was back up to 94bps on Friday.

European banking stocks fell 4.5 per cent on Friday while the S&P 500 index dropped 2.7 per cent.

“There is a lot of uncertainty about the exposure of banks and what kind of debt is on their balance sheets,” said Gerald Lucas, senior investment adviser at Deutsche Bank.