As the credit crisis deepens and more people are feeling the real impact as credit becomes more difficult to obtain, the focus on interest rates has never been greater. 12 months ago, only those connected to the financial services industry were aware of LIBOR and its importance in the marketplace. Today LIBOR is discussed in living rooms and pubs throughout the country with many of these discussions fueled by news reports on television.
The nation is now aware that LIBOR, the London Inter Bank Offered Rate reflects the actual rate at which banks borrow money from each other and is accepted as an accurate barometer of how global markets are reacting to market conditions.
The British Banking Association (BBA) takes the inter-bank borrowing rates from 16 contributor panel banks and looks at the middle eight of these rates (discarding the top and bottom four) and uses these to calculate an average, which then becomes that day's BBA LIBOR rate.
Over the last twelve months the difference between the LIBOR rate and the Bank of England base rate has been substantial and it has also been acknowledged that the period of this variation is also longer than ever before. There has recently been a drop in the rate with a 1.065 percentage reduction on Friday 7th November giving a rate of 4.496% (its lowest point since April 2004), reflecting a slashing of the interest rate by 1.5% to 3% by the Bank of England. The pressure has been put on the financial institutions to pass this on to the general public, not only by the government, but also by the media. With this in mind, many of the leading banks are following the Bank of England's lead.
But there would appear to be several things that have been overlooked in the rush to pass on the perceived benefits of the drop in the base rate.
Now, as I have said, the drop in the interest rate would seem to be welcome news for all concerned. But it pays to look at this from the banks point of view. If they pass on the rate drop and it applies to someone who is in payment arrears then this could be detrimental for both the customer and the bank. For example say you have a customer who has monthly payments of 350 and is in arrears of 300 would not necessarily be perceived as a risk. Now say the rate is passed on and his monthly payment drops to 280. This means that the customer is more than one month in arrears. This creates a domino effect because with each passing month the debt is not being cleared and more is being owed. It soon gets to the stage where this will be seen as a bad debt and put in the hands of solicitors for collection. Not a good position to be in.
Those bank's wishing to lend to other bank's at the LIBOR rate will take in to account the performance of the borrowing bank's mortgage book. This will have deteriorated considerably as a result of the rate cut and will deteriorate further with future cuts. This will obviously have a detrimental effect on a bank's willingness to lend, and could have a negative impact on LIBOR rates as the perception of risk increases, this will be priced accordingly.
This is however not the only form of funding. Banks fund loans and mortgages from retail deposits and the income derived from their existing loan book. Those banks that have continued to trade in recent months have managed to do so essentially on the back of retail funding, and the drive for investment business has been as aggressive as it was for mortgage business in recent years.
The drop in rates will mean that the income derived from borrowers will plummet, although banks will continue to grapple for investment business. Therefore the bank's profits will droop and their recovery will be made slower. As the banks fight for investment, the rates drop even below the LIBOR rate, meaning that the only way for banks to get liquid funds is through retail business. In that respect, LIBOR must then drop far enough to be attractive to banks in comparison with the cost of getting in retail business.
It has to be said that one good thing to come from the government proposals is that it has been a big confidence booster. But it is worth bearing mind that although the mood is slightly more upbeat of late, the drop in the interest rate and the injection of cash will also herald unforeseen problems as it aims to provide a solution to the problem. And, just to prove the point, as I write this the LIBOR rate has started to climb again.