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Minyan Mailbag: LIBOR vs. Fed Funds

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U.S. banks are getting liquidity at lower rates or through the discount window because the Fed is stepping in and allowing risky collateral to be accepted for the credit U.S. banks need right now.

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Mr. Practical,

So aren't LIBOR and Fed funds essentially similar things? Both overnight rates for banks to borrow from each other?

So why, if LIBOR is at 6.8%, can't everyone just borrow at Fed Funds or thereabouts? Or is there something I'm missing?

-David


Minyan David,

Fed Funds is the U.S. rate established by the Federal Reserve for banks to lend to other banks with U.S. operations. It is an artificial rate set by the Fed. If the market wants rates to go higher, the Fed must "create" dollars (create the credit themselves through REPO) in order to keep the rate where it wants it.

LIBOR is the rate at which the world's banks lend and borrow dollars outside of the U.S. to each other. It is essentially market-based as it is set by 16 large institutions.

LIBOR is currently 50-100 basis points higher than Fed Funds because there is huge demand for cash in dollars by the world's banks. There are so many dollars in the world, LIBOR is an important rate and LIBOR will naturally trade somewhat higher than Fed Funds due to a higher risk premium normally demanded by dollar holders to deposit outside the U.S. The current very wide spread is due to the high degree that all banks worldwide need cash in dollars to service debt (there is not enough low risk collateral left for banks to accept to lend dollars).

U.S. banks are getting liquidity at lower rates or through the discount window because the Fed is stepping in and allowing risky collateral to be accepted for the credit U.S. banks need right now.

-Mr. Practical
No positions in stocks mentioned.
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