Posted by: Dirk | October 16, 2008

LIBOR and EURIBOR – good indicators?

If the European bailout had to fix the banking system, how would we measure success? A lot of commentators enthusiastically mentioned rising stock prices, assuming that Monday’s instant reaction on stock markets would give the answer to whether the banking system was saved or not. This was too short-sighted, which is typical when you take stock markets as indicators for external events. What drives stock markets is still unknown – or as precise a term as “animal spirits”.

A better indicator could be the LIBOR, which is the interest rate at which banks in London lend money (dollars) to each other. There’s a cousin called EURIBOR, which covers the euro market and maybe that’s a better indicator for trouble in the banking system in Europe. Ciaran O’Hagan of Société Générale speaks out on FT.com:

FT: Something I find amazing as a journalist is that you have this incredible $10 trillion worth of loan contracts, which are basically based on this one small index calculated by one body. Do you think that perhaps it’s time to change aspects of the way that Libor is calculated?

CO: Well, there’s a need for an index. The purpose of the index is that it’s independent, verifiable, consistent, and the industry needs some kind of index. The question then is, is this the best index we have or could there be better ones? We’ve seen the development over the past decade or so of Euribor, which has really grown to be the dominant index within the eurozone.

So, $10 trillion worth of loan contracts is huge. But there’s more, according to Zubin Jelveh:

With about $300 trillion worth of contracts dependent on Libor (that’s $45,000 for every human being on the planet) and with the vast majority — like mortgage interest rate resets and non-financial corporate funding — not having anything to do with interbank lending, it’s clear that Libor is massively important for the entire economy.

The problem is that both LIBOR and EURIBOR might suffer from mis-represention of relevant interest rates by banks. Also, a change in the publics or banks liquidity preferences can influence both rates. However, a government bail out must cause a decline in the LIBOR and EURIBOR if it is to deliver what had been promised – release of stress from the banking system and a kick-start for lending. Whether this is the biggest macroeconomic problem is open to discussion. Growth forecasts for Europe are gloomy because of faltering demand. The more the governments spend on banks, the less they will be able to stimulate demand. Which is possibly its next task. With the Stability and Growth Pact in place, some European governments will be running out of room to maneuvre soon. But there is an easy solution for this.

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