Another myth that needs debunking

Since the start of the credit crunch, more intelligent commentators pointed out that LIBOR (the rate at which banks lend to each other) has been much higher; both relative to BoE base rate and relative to pre-credit crunch days. This is an important measure, as it indicates the degree to which banks (mis)trust each other, and they are the ones who ought to know best.

*rant*

Dumber commentators have now become obsessed with LIBOR, leading to twatty statements as in today's Metro:

The latest reductions come following a sharp fall in the key inter-bank lending rate three-month Libor earlier today. The rate, upon which variable rate mortgages are based, fell by around 1% to just under 4.5%, to leave it standing 1.5% above the base rate. While this is still well up on its long-term average of being between 0.15% and 0.2% higher, it is encouraging that two-thirds of yesterday's reduction has been priced in in one go.

So banks still trust each other a lot less than before (understandably) but it is a complete myth that mortgage rates are based on LIBOR any more than they are based on the BoE base rate - the rate at which banks can borrow from BoE are always base rate plus risk premium, normally 1%, or "100 bps (basis points)" if we're trying to sound flash.

By far the biggest source of funds on which banks pay interest is current accounts, savings accounts, money markets, bonds, mortgage backed securities, SIVs, whatever, this is what dictates banks' borrowing rates. As banks typically have to make a one or two per cent spread between lending (i.e. mortgage) rates and borrowing rates, it is these borrowing rates that matter. The lending rates and borrowing rates each have their own supply/demand curves of course, but competition (ha!) between banks ensures that the spread is within a fairly narrow band.

Unless banks are going to be funded by ever larger taxpayer-funded bail-outs (not unlikely), it is the average rate that they pay on deposits, bonds etc that is relevant. Not bloody LIBOR and not the bloody BoE base rate. If anything, it is mortgage rates that influence LIBOR - if a bank has a choice between lending to mortgage borrowers, with all the associated risks and faff at X%, they are probably willing to lend short term to other banks at X% plus/minus small risk premium either way.

*/rant*