Banking system overheats after essential lubricant clogs up

In normal times the word Libor remains an esoteric term best left to the world of banking. But yesterday saw central banks around the world throw hundreds of billions of dollars, pounds and euros into money markets as Libor - the rate at which banks lend to each other - surged in response to the collapse of Lehman Brothers and worries over insurance group AIG.

Looking at Libor is a bit like peering at what goes on under the bonnet of the banking machine. Yesterday things did not look pretty: the engine was overheating and came close to seizing up before big injections of lubricant from central banks kept it turning - just.

Libor stands for the London inter-bank offered rate, and is the main interest rate in the London wholesale money market for pounds, dollars and euros. Unlike Bank rate, which is set by the Bank of England, Libor is set by the demand and supply of money as banks lend to each other to balance their books on a daily basis.

Loan periods range from overnight up to one year and it is used to price all kinds of financial instruments including floating-rate mortgages. Instruments in several other currencies are also priced relative to Libor, such is the size of the London market.

The focus yesterday was on the overnight Libor rate as banks, which normally spend all day buying and selling money from each other and thereby keep the wheels of global finance turning, again became reluctant to lend to other institutions in case they turned out to be another Lehman.

Normally, overnight Libor tracks very closely central bank interest rates in their respective currencies, often running at 0.1 or 0.2 of a percentage point above them.

Yesterday, overnight dollar Libor jumped to 6.4% in its daily fix by the British Bankers' Association, up from 3% on Monday. That rate was the highest since January 2001, when the Federal Reserve's official rate was 6%, compared with 2% now.

In US money markets, dollar overnight money market rates jumped to above 10% at one point, more than five times the official Federal Reserve rate.

The Fed flooded $70bn (£39bn) of temporary liquidity into money markets, adding to the same amount it had provided on Monday. Although that was only half the amount the markets bid for, the move succeeded in pushing overnight rates back down to 2%.

These daily injections are the biggest since September 2001, when the Fed moved to free up cash flowing to the financial system in the aftermath of the attacks on New York and Washington.




