Saturday, October 11, 2008

Bringing Down LIBOR

I'm not an economist, though I'm going to play one on the intertubes today.

Several people (one such example) have thrown around the idea of the Federal Reserve guaranteeing interbank loans. The basic idea seems reasonable to me. It could slow the bleeding. However, it is unclear how such a program would eventually be unwound, and what happens to the system when the Feds decide to end the program. Would irrational risk aversion cascadingly reassert itself?

If the Fed is going to be in the business of insuring something then they should be paid for their trouble. Perhaps only a quarter percent. If Fed intervention brings down LIBOR by several percent, then 25 basis points seems like an attractive premium for counter-parties to pay.

Perhaps most importantly, this insurance should be optional - if not at first, at least after some time has passed. This would allow the banks to wean themselves off the insurance gradually as they decide that taking on additional risk is worth forgoing the insurance penalty.

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