As most of you will be aware, the historic relationship between Bank Base Rate (BBR or repo rate) has broken down over the last twelve months as inter-bank lending has all but stopped. Rather than 3 month London Inter-Bank Offered Rate (LIBOR) exceeding BBR by a long term average of circa 13bps, it had moved to as wide as 178bps in recent weeks.

Whilst the relationship between BBR and LIBOR remains far from the historical average there have been some signs in recent weeks of the gap tightening - particularly after the recent dramatic cuts to BBR.

The LIBOR/BBR spread remains an important indicator of the health of the banks and the level of trust within the banking system. A wide difference between BBR and LIBOR indicates not only a shortage of available funding but an unwillingness of banks to lend to each other. The Feds decision to allow Lehman to fall sent shockwaves through the markets, bringing inter-bank lending to a virtual standstill and LIBOR rates spiralling again (see graph below). The gradual recovery since this time stems largely from widespread government intervention in the system, by pumping of billions into both the banks directly themselves and indirectly into the money markets.

Whilst the level of inter-bank lending remains low, with lenders very reliant on retail depositors, the signs at this stage are at least positive that we are on the road to recovery. Exactly how quickly and indeed if we ever return to the previous long term equilibrium remains open to debate. When we get here though, advisors and customers will need to better understand how LIBOR works as this will be the basis for many tracker products.

To keep an eye on LIBOR click on the ‘Money Markets’ link on this page.