Are cash-strapped banks holding down Libor?

A new sign of the heavy stress on the banking system: Banks may be driving down the closely watched Libor measures of interbank lending rates by underreporting their borrowing costs. Why? Because, The Wall Street Journal reports, “they don’t want to tip off the market that they’re desperate for cash.” Though the Federal Reserve has put in place ample measures to ensure that cash-strapped banks and brokerage firms can borrow from the Fed in an emergency, it was only a month ago that Bear Stearns (BSC) collapsed following the mass exodus of its hedge fund customer base, and evidently that example looms over the market.

Of course, the notion that statistics are being played with is nothing new. There’s a long-running debate in the media and the blogosphere as to how badly the government distorts its unemployment data, for instance. But the fact that some people believe Libor rates are being artificially depressed is remarkable, because even the artificially depressed Libor has soared in recent months as the credit crunch has worsened. The spread between three-month Libor and the comparable U.S. Treasury note was 1.58 percentage points Tuesday, the Journal reports - more than five times as large as the average spread in the five years up to August 2007.

Yet Scott Peng, an interest-rate strategist at Citi (C), indicates that an accurately reported Libor number could be as much as 0.3 point higher, the Journal reports. He adds that “the long-term psychological and economic impacts this could have on the financial market are incalculable.”