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Banks' Strong Funding Position, Low Libor Means Libor Is Broken Again

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Apparently a fun thing to do is to freak out about how Libor is losing its magic as an indicator of whatever it is an indicator of. Since it's an indicator of interbank lending rates (being an interbank lending rate and all), news suggesting that it may provide a false signal of bank borrowing costs is interesting.

Today though we get (Money & Investing front-page) news that Libor is "losing its clout as a macroeconomic indicator," by which the WSJ appears to mean that low Libor fixings are not giving everyone enough reason to panic:

There are several reasons why banks are borrowing less from one another in the Libor market. In the U.S. and Europe, regulators have given banks cheap access to their lending facilities since the 2008 panic. And in the past two years, banks have received a flood of cash from depositors and sought to reduce exposure to other banks and the amounts they borrow.

In the U.S., banks have ratcheted up funding operations from customer deposits, which are viewed as less risky than interbank loans. "Retail deposits are desirable because they are stable," says Jeff Herzog, an economist at BBVA Compass in Houston.

Moreover, the Fed's second round of quantitative easing—known in the markets as QE2—has played a role. That program established a $600 billion bond-buying program. After the Fed sold Treasury bonds to investors, some of the money ultimately was routed to non-U.S. banks. Additionally, banks were able to sell IOUs cheaply. The banks then parked the money at the Fed to earn interest, building up a large cash base and lessening the need to borrow from other banks.

In other words, banks can borrow cheaply in the interbank overnight market because (1) they have reduced demand for overnight interbank lending by obtaining cheap and relatively stable sources of funds like central banks and depositors and (2) monetary policy has lowered interest rates. Which all seems good, but is apparently terrible. As the Journal puts it,

The upshot: Libor these days is less representative of banks' health and could mask deeper problems in the credit markets, analysts say.

That seems like a stretch. Try some Mad Libs with this story: the 2.94% yield on the 10-year is less representative of the Treasury's health (less than what?) and could mask deeper problems in the government's budget. Totally true! But, y'know. Supply and demand. And not a reason to stop caring about Treasury rates.

No doubt there's a lot to worry about in the banking system, especially dubious sovereign exposure in Europe but also finding enough office space to house David Viniar's army of successors. But there are also goodthings. Like oodles of cheap stable funding from retail deposits and central banks that's reduced reliance on short-term interbank lending. And the market has priced those things, in an extremely low yield environment, and the result is a pretty low Libor.

Libor, or the Libor-OIS spread that the Journal's analysts also fuss over, is not an all-purpose panic gauge for credit markets. Actually we confess that, with some exceptions in 2008, we've always kind of thought of Libor as a risk-free rate. When Libor blows out because banks are desperate for funding but afraid to lend to each other, that's news. When Libor is low because banks have plenty of funding and aren't particularly worried about lending to each other, that's ... kind of normal.

Key Credit Gauge Loses Clout [WSJ]