INVESTING: Credit crunch touches off squabble over Libor rate

The accuracy of a key global interest rate has been under scrutiny since the credit market crisis surfaced last summer.

The London-interbank-offered rate, known as Libor, is used to determine interest rates on more than $350 trillion in financial instruments around the world-note that was “t” for trillion. Many mortgages, fixed-income securities, consumer and corporate loans, and derivatives use Libor as a base rate when setting their interest rates.

Libor is administered by the British Bankers Association, which once a day asks 16 banks (three of them based in the United States) to provide rates on how much it would cost to borrow from each other for 15 different maturities, from overnight to one-year, in 10 different currencies. The four highest and lowest quotes are thrown out and the average interest rates are posted at 11:30 a.m. London time.

Since the credit crisis began, concern has grown that some of the banks providing Libor quotes have been underbidding on rates to avoid being seen as having difficulty raising financing. The BBA had been resisting any major adjustments to its system, which has been in place for 24 years, fearing that drastic changes would create even more uncertainty in the markets.

However, yielding to concerns, the BBA recently announced it would add more banks to the rate-setting mix, and that it might initiate a second rate-fixing process after the U.S. market opens each day. It also said it would introduce measures to ensure that banks are providing accurate quotes.

The process of determining Libor came under fire last August. With the meltdown of the subprime mortgage market, banks suddenly were wary of lending to each other. For example, on Aug. 20, the three-month Libor rate rocketed 2.4 percent above the three-month rate on U.S. Treasury bills.

Even today, signs of stress are still evident in the credit markets. For example, the three-month Libor remains around 0.9 percent above three-month Treasury bills. Some observers believe the wide spread indicates that things in the credit markets will get worse before they get better, and that until bank balance sheets get cleaned up and recapitalized, markets will continue to be skittish.

Critics who have called out the Libor “lie” suggest that banks are routinely misstating borrowing costs to understate their financial problems. For example, UBS, the large Swiss bank that has incurred $38 billion in write-downs on subprime securities, quoted rates to the BBA below the stated Libor 85 percent of the time between July and April. The implication here is that even the elevated Libor rates have been kept artificially low in the context of this credit crisis.

Of course, financial institutions are aware of the importance of perception to other market participants, in that any actions that would be viewed as a distressed maneuver would not be taken well by other financial players in the market. As such, the BBA wants to address ways to reduce the stigma that might be associated with a bank that provides quotes higher than their competitors. One potential solution is to set Libor rates based on actual trades, rather than on a survey.

Regardless, changing the process to determine Libor will not solve this overriding issue: Amid today’s global credit crisis, banks are having a difficult time borrowing money.