Readers of Liar’s Poker, Michael Lewis’s rites-of-passage account of life inside Salomon Brothers in the roaring 1980s, will recall that Libor is the first financial acronym that the author, a fledgeling bond salesman, is forced to learn.

Thanks to this summer’s gyrations in benchmark interest rates, those with even the most cursory concern in the British banking sector – and that includes the hundreds of thousands of retail investors still holding windfall shares from building society demutualisations – are having to digest it too. Not that the nitty-gritty of how the London Inter Bank Offered Rate is calculated every day need detain them too long.

What it is important to grasp about this usually overlooked barometer is the very reason it has been making headlines in the financial pages over the past few weeks: its uncomfortable premium over Bank of England base rates. Whereas three-month Libor – the rate at which banks are prepared to lend money to each other over 90 days – usually sits at 0.12 percentage points above base, that gap has abruptly risen to 1.14 percentage points, its biggest in 20 years. Yesterday, it sat at 6.89 per cent, against base rates at 5.75 per cent.

What that signals is that banks are suddenly unwilling to lend to each other. They would rather keep any spare funds for themselves as a protection against unforeseen strains on their balance sheets – such as the need to bail out off-balance sheet investment vehicles – rather than lend it to other banks, which, because of a similar problem, might find it difficult to pay them back. For that reason, the Bank of England this week promised to provide up to £4.4 billion of extra reserves against which institutions could borrow.

All this is good news for savers, who this week saw some building societies nudge up their rates on fixed-rate savings accounts to a healthy 6.86 per cent. But it is adverse both for mortgage borrowers and, more specifically, owners of shares in the banking sector, which, having lagged the stock market by 11 per cent since January, is already one of the worst performers in the FTSE all-share this year. According to Jonathan Pierce, banking analyst at Credit Suisse and a long-standing bear of the sector, the Libor problem could trigger downgrades to 2008 profit forecasts of at least 10 per cent.

The bind is threefold. First, it threatens to hit profits at banks that are heavily reliant on sourcing funds from the wholesale money markets, rather than their own savers’ deposits. This predicament has been lessened to a degree by the recent popularity of fixed-rate mortgages, which now account for 44 per cent of outstanding UK home loans, against 30 per cent two years ago. Banks typically swap out these loans into floating-rate instruments that are in some way pegged to Libor, so the effect is contained.

Even so, Credit Suisse estimates that HBOS and Northern Rock – the two British banks most vulnerable to the mismatch – have a net negative exposure to the Libor gap of £12.7 billion and £12.6 billion respectively. For every 0.1 percentage point difference between Libor and base rate, HBOS’s profits fall by about 0.2 per cent and Northern Rock’s by nearly 2 per cent. Should, for example, the current 1.14 percentage point gap persist for a year, profit forecasts for the pair would have to fall some 2.3 per cent and 22 per cent respectively.

Second, banks are likely to make less profit from their retail deposits. With revenue growth from both mortgages and unsecured lending having been sluggish over the past 12 months, rises in retail deposit revenues have been a key contributor to the sector’s bottom line. As is customary, banks have been able to profit from rising base rates by deferring passing them on to savers.

However, as long as Libor stays high, banks will increasingly seek to raise funds from their own depositors, rather than the wholesale market. Increased competition for such money and the speed with which banks raise their rates will inevitably drag on profitability. In the past week alone, Halifax and Northern Rock have announced substantial increases to savings rates for their online customers. Credit Suisse calculates that a fall of 0.1 percentage points in retail deposit margins will wipe 2 per cent off the sector’s profits.

Finally, a prolonged period of high Libor rates is likely to trigger a rise in corporate bad debts. About 60 per cent of bank loans to British companies are priced off Libor. At current levels, companies are likely to be paying an 8 per cent rate of interest on their debt, against 6.5 per cent at the start of this year. Again, a 0.1 percentage point rise in corporate bad debts would hit Credit Suisse’s sector forecasts by 2 per cent.

All good reasons to avoid the banking sector for now – and to expect unscheduled trading updates from its constituents before the traditional late-November start of the year-end reporting season.

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