"I'm wondering if someone among your collective can clarify how LIBOR relates to bank funding costs? With LIBOR and the TED spread at almost record lows, I had assumed that should mean banks are now willing to lend to each other at very low interest rates. I realise the TED spread is $US denominated, but am puzzled why banks in Australia continually complain that wholesale funding is expensive while $US LIBOR is so low. As an example, major Australian banks (reputed to have strong balance sheets) are offering 6%pa for 6 month term deposits while our central bank overnight target cash rate is 4.0% (up yesterday by 0.25%). Is LIBOR really a measure of the rates banks lend to each other or is it determined some other way e.g. via prices on a futures market?"

Eoin Treacy's view Thank you for this question which I'm sure will be of interest to other subscribers. The London Inter-Bank Offered Rate (LIBOR) is at historically low levels in US Dollars and a number of other currencies, and keeping pace with rate increases in countries such as Australia.

The TED spread which is the difference between 3-month US Dollar LIBOR and 3-month T-Bill yields is generally viewed as a measure of risk in the banking sector because it illustrates the premium over Treasuries at which banks are willing to lend to one another. However, the present situation is not exactly normal.

The Fed raised the discount rate by a 0.25% two weeks ago to 0.5%. This made it slightly more expensive for banks to borrow at the Fed's discount window. Banks continue to have access to extraordinarily cheap credit from the Fed, which left them with zero counterparty risk. The discount rate hike made this service slightly more expensive but rates are still accommodative.

The vast majority of banks have experienced considerable impairment to their loan books. This means that they need to boost their reserves in order to shore up their balance sheets; making allowances for further losses and defaults. The desire to boost reserves is at least in part why they are offering such attractive interest rates for term deposits in Australia.

Due to the more cautious attitude banks are now required to take toward their lending habits, they need to take a much more stringent approach to counterparty risk. Since they have been able to access cheap credit at the discount window with no counterparty risk, there is no incentive to lend to another institution with an opaque balance sheet.

So in answer to your question, yes, LIBOR is the rate at which banks lend to each other but as long as interest rates remain close to zero and banks can access credit via the discount window, the interbank market is likely to remain comparatively illiquid. If the Collective have any additional thoughts on this subject I would be happy to reproduce them in Comment of the Day.