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Looking at the inter-banking liquidity

Written by A Forex View From Afar on Thursday, September 25, 2008

Usually, when a bank wants to make a loan for liquidity needs it has two options: either borrow money from the central-bank, through the open market operations, or call another bank to lend money at the LIBOR rate. The London Inter-bank Offered Rate or LIBOR is the reference rate at which banks lend money each other.

A major distinction between those two would be that banks need collateral in order to access money from the central bank, while there is no such need when accessing funds from a fellow bank. This would imply that money accessed through the LIBOR rate, would be more expensive (a higher interest rate) because the loans are not secured.

In order to measure the liquidity from the inter-banking environment, investors use the Libor-OIS spread. The index measures the spread between the costs of accessing money throughout the LIBOR rate on a three month loan and the overnight rate at which banks would access funds from the central bank. Usually, the spread is just a few basis points, less than 10 (or 0.1%), however, today the spread reached a massive 166 basis points (or 1.66%). This is the highest spread recorded since 2001, showing that there is a massive lack of liquidity.

The other alternative for a bank would be to access money from the local central bank. The recent open market operations held by the SNB and ECB showed that this is mainly what banks do. The ECB auctioned $25 billion yesterday with a maturity of one month, and received bids valued at $110. The average rate at which banks accessed the $25 billion was 3.75%, while the LIBOR rate with one-month maturity reached 3.20%. This shows that banks decided to have a rush at the central bank’s offer, despite funds from private banks being much cheaper. In normal market conditions (which these are not), the LIBOR would be bigger than the open market’s interest rate, since a LIBOR loan implies additional risk, requiring a bigger premium.

This does not have a direct effect over the currency charts, but it shows that banks are not lending to each other, fearing that bankruptcies may continue. Put head to head, it shows the financial system is a long way from recovering. As such, trade desksmay not be willing to take risk onto their balance sheets, meaning the high yielders (the plural from yielder) and the yen will just hover around the support/resistance levels on the charts. Assuming, of course, that no news hits the wires that cause a different reaction.

Quoting from an old London high street joke, the LIBOR is the rate at which bank’s do not lend to each other.

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