Banks and LIBOR

There's a certain confusion doing the rounds about what LIBOR is and does. To define it, LIBOR is simply the rate at which banks lend to each other (without going into any more boring detail).

But it isn't the rate at which the Bank of England will lend to banks, nor is it the rate at which the banks borrow our savings and deposits to lend to other people. Those are rather lower, so why is it that LIBOR is the starting point for the rates at which the banks will lend to us?

Why don't the banks borrow from us or the BoE, add their necessary mark up and risk premium and lend at those rates? Why are they using the higher LIBOR and then adding their costs and risk premia?

Because of that economist's old standby, opportunity costs.

LIBOR is the rate that they can lend at without all those costs of retail lending, without all that effort put into whether Worstall T is going to be able to keep churning out paid commentary in the difficult times ahead, without having to estimate those individual risk premia.

If they borrow my savings, or the BoE money, and lend it out at less than LIBOR, or less than LIBOR plus those extra costs of retail lending, then they are forgoing a profit opportunity. They are making less profit than they could.

Which, of course, as profit maximising institutions, they don't do.

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