We are getting further into the credit crisis, and as we do so, people are finding it more difficult to get credit for anything. This is causing people to look even more closely at interest rates than ever before. A year ago, Joe Public wouldn’t have had a clue what LIBOR was or what it meant. Only those in the financial industry were aware of its meaning. Nowadays it is common knowledge, and a very hot topic.

It is now common knowledge that LIBOR, or London Inter Bank Offered Rate, which indicates the rate that the financial institutions borrow from each other, is the true reflection of how the world markets are reacting to the changing conditions within the sector.

The British Banking Association (BBA) works out the BBA LIBOR rate on any given day by taking the inter bank borrowing rates from 16 contributor panel banks and analyses the middle eight rates (dismissing the first 4 and the last 4) to arrive at an average rate.

The gap between the LIBOR rate and the Bank of England base rate has for the past year, been large by historic standards and this gap has been more prolonged than ever before. The rate has reduced slightly over recent weeks culminating in the 1.065 percentage point reduction on Friday to 4.496 its lowest since April 2004 this after the Bank of England slashed interest rates by 1.5% to 3%. There has also been a great deal of pressure placed on banks from both the government and the media to pass on these rate cuts to customers. Many of the leading banks have now shown a commitment to following the Bank of England’s lead.

But there would appear to be several things that have been overlooked in the rush to pass on the perceived benefits of the drop in the base rate.

Current customers will of course welcome a reduction in interest rates. For the bank, however, this can have a damaging effect on arrears performance. As borrowers are set to pay less monthly, this automatically puts up arrears percentages. For example, if a borrower normally pays 350 a month, but is 300 behind, they are effectively not an issue as yet. However, if those monthly payments are brought down to 290, that 300 in arrears is considered to be over a month’s worth of payment, which then puts them on the problem list. This will have a knock-on throughout, as people who are 1month behind move to 2, 2 to 3 and so on. Therefore, the amount of people being litigated against will also increase.

Banks who wish to lend to other banks at the LIBOR rate will be looking at the performance of the borrowing bank’s mortgage book. This will inevitably have slipped with the decrease in rates, and will of course only slip further as more cuts happen in the future. As a result, banks will become more unwilling to lend out as the possible risk of lending increases, which will in turn be detrimental to the LIBOR rate.

This is however not the only form of funding. Banks fund loans and mortgages from retail deposits and the income derived from their existing loan book. Those banks that have continued to trade in recent months have managed to do so essentially on the back of retail funding, and the drive for investment business has been as aggressive as it was for mortgage business in recent years.

The drop in rates will mean that the income derived from borrowers will plummet, although banks will continue to grapple for investment business. Therefore the bank’s profits will droop and their recovery will be made slower. As the banks fight for investment, the rates drop even below the LIBOR rate, meaning that the only way for banks to get liquid funds is through retail business. In that respect, LIBOR must then drop far enough to be attractive to banks in comparison with the cost of getting in retail business.

To summarise, there is little doubt that the government’s actions have boosted confidence levels and created a positive impact on the money market. However there is still a long way to go, and many more challenges to overcome, and the cash injection and reduction in interest rates, although remedial, will still have a few nasty side effects. The irony is, as this article is written, LIBOR has gone back up to 5.65%, so who knows what to expect!