Fears as Libor fails to mirror base rate cut

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Libor divergence
Libor divergence

Further proof that Britain’s money markets are moving beyond the Bank of England’s control emerged yesterday as the cost of inter-bank borrowing failed to respond to Thursday’s quarter point cut in base rates.

Economists and bankers expect the London inter-bank offered rate (Libor) – the cost of borrowing between banks – to mirror any move in base rates. However, three-month Libor fell just 3 basis points, from 6.64pc to 6.61pc, yesterday after the 25 point cut in base rates to 5.5pc.

The divergence between the two markets, of 111 basis points, is now at its most extreme since the height of the liquidity crisis on September 11, when the gap was 115 points.

After appearing to abate in October, the credit crunch has intensified again as banks look to protect their balance sheets ahead of the year end. Economists fear that the Bank could lose control of monetary policy unless Libor falls back in line with base rate, with grave implications for the wider economy. Mortgage lenders tend to price their variable rates off three-month Libor, which is also a key determinant in the cost of borrowing for businesses.

Peter Spencer, chief economic adviser to the Ernst & Young Item Club, said: “The market rather than the Bank is now dictating monetary policy. If this problem is not sorted out in the next two to three months we’re looking at major insolvencies in UK plc.”

Libor has shot up because banks want to report as strong year-end figures as possible. They fear lending to other banks in case credit market problems cause repayment to be delayed or in case they need to move off-balance sheet funds on to its books. If they do not have enough capital to set against the loans and funding, their financial strength will be eroded.

Jim Reid, a debt specialist at Deutsche Bank, said: “The rate cut may be having no effect on Libor but there is relief that the Bank is sending a message that it is trying to ease the crisis in the credit markets. It’s ability to do much until after the New Year effect is limited.”

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