How the Libor is determined

May 18 (Bloomberg) -- The cost of borrowing in dollars between banks dropped by the most in two months as record low interest rates and rising customer deposits quicken the thaw in lending.
The London interbank offered rate, or Libor, for three- month loans fell four basis points to 79 basis points today, the biggest decline since March 19, according to British Bankers’ Association data. It declined 11 basis points last week, the most since January.
“The rate of decline has increased the last few days and it seems there’s more money around,” said Peter Chatwell, a fixed-income strategist in London at Calyon, the investment- banking unit of Credit Agricole SA. “Things are progressing nicely. It’s looking positive.”
The availability of credit has improved as the Federal Reserve committed $12.8 trillion to stem the longest recession since the 1930s and central banks around the world cut interest rates to near zero. Libor, used to set borrowing costs on about $360 trillion of financial products globally, according to the BBA, has declined from as high as 4.82 percent in October, after the collapse of Lehman Brothers Holdings Inc.
The TED spread, the difference between what banks and the U.S. Treasury pay to borrow for three months, narrowed one basis points to 66 basis points, the lowest level since August 2007, when the credit crisis began. The Libor-OIS spread, another gauge of banks’ reluctance to lend, narrowed five basis points to 58 basis points, the least since March 24, 2008.
Still Wary
Libor has dropped more than two basis points for the past four days. The last time it fell so much was in the four days through Jan. 13.
Some measures show financial institutions are still wary of lending after banks racked up more than $1.4 trillion of writedowns and losses since the start of 2007.
The difference between the Fed’s target rate for overnight bank loans between banks and three-month Libor was 53 basis points today, compared with an average of 22 basis points in the five years before credit markets froze.
“People have become a bit more relaxed now because we haven’t had any bad news recently,” said Jan Misch, a money- market trader in Stuttgart at Landesbank Baden-Wuerttemberg, Germany’s biggest state-owned bank. “On the other hand, I doubt the turnover has increased at the same pace. We’ve now reached a level where I wouldn’t expect further declines.”
Rising Deposits
The drop in Libor has less to do with rising confidence among financial institutions than it does with surging customer deposits, Jim Vogel, an analyst at FTN Financial said last week. Deposits at U.S. banks jumped by almost $400 billion in the past six months, contributing to reduced demand for loans in the interbank market, Vogel wrote in a note to clients May 11.
Libor is derived from a survey of banks conducted by the BBA each day in London. Institutions are asked how much it would cost them to borrow from each other for 15 different periods, from overnight to one year, in currencies from dollars to euros and yen. The BBA then calculates averages, throwing out the four highest and lowest quotes, before publishing them before noon.