LIBOR Becomes A Bit More Accurate, So Financial Crisis Becomes A Bit Worse

[Source: Institute of International Finance, Washington, DC]
Continuing on the theme of the unusual spread that banks currently have to pay to borrow from each other since August (due to credit risk and liquidity concerns): a Wall Street Journal article on April 16, the day after my last post, explained that LIBOR had recently lost some of its reliability. The true spreads were even higher than what the panels of banks were reporting to the institution that calculates LIBOR, the British Bankers Association (BBA). Banks can have an incentive to act strategically in the interest rates that they report to the BBA. Even though the highest and lowest respondents are dropped from the computation, that was not enough of a correction. But the Wall Street Journal reported the next day that the banks had immediately reacted to this news by increasing the honesty of their interest rate numbers. The updated version of the LIBOR graph exhibits an upturn in the US interbank rate at the very end.
Good news, in that it suggests that LIBOR is again reliable, which matters because many economically important borrowing rates are keyed off of LIBOR. But it is also bad news, in that an increase in the official LIBOR then has a contractionary impact on the real economy — again because so many economically important borrowing rates are keyed off of it. LIBOR has risen about 50 basis points since the last Fed interest rate cut, including 25 basis points in just the last week. It seems likely that the latter rise is the manifestation of the restoration of LIBOR’s truthfulness..