Each market day, the British Banker’s Association (BBA) releases the a single London Interbank Offered Rate (LIBOR) that tells investors the average price banks are charging each other for U.S.-dollar denominated loans. While this number—which gives us a glimpse into the health of the global banking system—is extremely important, it doesn’t tell you the whole story.
To get the whole story, you have to dig into how the LIBOR is calculated.
[VIDEO] Understanding the LIBOR Spread
The LIBOR Spread
To calculate the LIBOR each day, the BBA surveys 16 different banks to find out what rate each one is charging for its overnight loans made to other banks.
Naturally, each bank is going to have a unique rate it is charging. For example, on May 27, 2009, the 16 banks the BBA surveys were charging the following interest rates:
| – Bank of America: | 0.65 percent |
| – Bank of Tokyo-Mitsubishi UFJ Ltd: | 0.73 percent |
| – Barclays Banks plc | 0.63 percent |
| – Citibank | 0.65 percent |
| – Deutsche Bank AG | 0.62 percent |
| – HSBC | 0.63 percent |
| – JP Morgan Chase | 0.62 percent |
| – Lloyds Banking Group | 0.66 percent |
| – Mizuho Corporate Bank | Unavailable at this time |
| – Norinchukin Bank | 0.73 percent |
| – Rabobank | 0.67 percent |
| – Royal Bank of Scotland Group | 0.72 percent |
| <- Societe Generale | 0.68 percent |
| – Sumitomo Mitsui | Unavailable at this time |
| – UBS AG | 0.73 percent |
| – WestLB AG | 0.68 percent |
As you can see in the list above, the Bank of Tokyo-Mitsubishi UFJ Ltd. and UBS AG are charging the highest rates—0.73 percent—while JP Morgan Chase is charging the lowest rate—0.62 percent.
The difference between the highest rate—0.73 percent—and the lowest rate—0.62 percent—is the LIBOR spread, which in this case is 0.11 percent (0.73% – 0.62% = 0.11%).
This is a relative large spread compared to how low the overall LIBOR rate is.
When the LIBOR spread is high, it shows there is more concern in the banking sector that not all of the banks are on sound footing and there is a heightened default risk. When the LIBOR spread is low, it shows there is less concern in the banking sector that not all of the banks are on sound footing and there is a low default risk.
The LIBOR spread is an often overlooked piece of information that gives us an idea of how healthy the banking system really is. Remember, banks may say they are doing well and they believe other banks are as well, but when the rubber hits the road, you can really tell how banks feel about other banks by looking at the interest rates they charge them when borrowing funds.