From the FRBSF Economic Letter:
One of the key features of the financial turmoil of the past year has been the credit crunch. For borrowing of many kinds, terms are tougher and interest rates are higher, reflecting skyrocketing risk premiums. Of particular importance are the elevated risk premiums on interbank loans—loans that banks make to each other. The higher rates at which banks fund themselves can raise the interest rates borne not just by bank borrowers, but also by nonbank borrowers whose loan rates are tied to some of these interbank funding costs. One consequence of these higher rates is that they partially offset the effects of the monetary easing that the Federal Reserve has implemented since the fall of 2007.
The London interbank offered rate, or Libor, is such a rate, and it is widely used. Estimates are that, worldwide, a total of around $150 trillion of financial products—in both the business and consumer sectors—are indexed to the Libor. In addition, derivatives based on the Libor are traded on futures exchanges.
As important as it is, the Libor is an indicative rate rather than a true transaction rate. The Libor Fixing evolved in the early 1980s when the British Bankers' Association (BBA) developed it to measure interbank funding costs at a fixed point in time every day. Currently, the Libor Fixing is set every business day at 11 a.m. U.K. time in 10 currencies and for several maturities. A panel of banks, chosen by the BBA, reports the rate at which they perceive they could raise unsecured funds in a market of reasonable size just before the 11 a.m. fix time. The average is calculated after screening out high and low rates and is published as the BBA Libor Fixing at 12 noon U.K. time.
This Letter explores the behavior of the risk premium in Libor rates during the current crisis, considering both the credit risk portion and the liquidity risk portion. Specifically, it examines the short-term (three- to six-month) Libor, because the interbank funding market is most active in shorter maturities. In addition, the focus is on the U.S. dollar (USD) Libor, which is expected to be different from the Libor denominated in other currencies due to differences in the general levels of interest rates across countries. However, the discussion here applies to other major currencies, including the pound sterling, the euro, and the yen.