24 Aug 2015 15:57 IST

What is LIBOR and how does it work?

The London Inter-Bank Offered Rate is a set of average interest rates that play a crucial role in the credit market

The five-letter acronym LIBOR stands for London InterBank Offered Rate, and is a set of daily average rates at which banks can borrow money from one another — that is, the interest rate that banks can charge for short-term or unsecured borrowings.

Given below is an example showing the LIBOR rates for the British Pound, the Euro and the dollar as on August 19, 2015 (see Table).

Let me also mention that just because the word “London” appears in the acronym, it does not mean it is relevant to the City of London alone! As you can see from the example, rates are given for the Euro and the dollar too. Therefore, LIBOR has different names, depending on the currency with reference to which the interest is calculated.

For instance, for the British Pound it is called LIBOR, for Euro it is EURIBOR and for Dollar it is US LIBOR.

Therefore LIBOR’s significance spreads far beyond the City of London. In fact it is the world’s most important “benchmark” rate that is widely used as a reference rate for financial instruments and loan products, which add up to hundreds of trillions of dollars across the globe!

These financial instruments include various debt instruments, corporate bonds, treasury instruments, mortgage loans, education loans, credit cards as well as derivatives such as currency and interest swaps, among the plethora of financial products.

More important, banks, financial institutions, and credit agencies all over the world look to LIBOR to set their own interest rates.

So LIBOR rates are like “benchmark rates,” which are widely used as base interest rates by financial institutions the world over.

Another prominent characteristic of LIBOR is that it helps assess the current state of the world’s banking system as well as to calibrate the movements so as to set the opportunities and outlook for future central bank interest rates.

Okay, so how is LIBOR used by a bank to set the interest rate it charges a borrower?

LIBOR, being a benchmark rate, represents the lowest borrowing rate among banks. The Bank charges a risk premium on top of the LIBOR, based on the credit risk of the borrower. This is often expressed as “LIBOR + X bps” where, bps stands for ‘basis point’ and X is the premium charged over and above the LIBOR rate.

I noted three currencies above, but can the rate be obtained for all currencies?

No! Not all currencies. It is currently calculated for five currencies (the US Dollar, Euro, British Pound, Japanese Yen and Swiss Franc) as these are majorly traded, and is calculated for seven lending periods, ranging from overnight to one year, as you would have noted in the above example.

Therefore, in total, there are 35 different daily LIBOR rates (five currencies and seven maturity periods).

Why was LIBOR created and by whom?

During the early 1980s, financial institutions found a growing need for benchmark rates to calculate the lending rates on a number of financial products including derivative products such as interest swaps and options.

Given this need, the British Bankers’ Association (BBA), which is an industry trade group, took the initiative and started publishing the rates since January 1, 1986.

This published rate was called BBA LIBOR.

How has LIBOR’s use evolved over time?

As one can appreciate, LIBOR was primarily created as a standard or a benchmark for banks to determine borrowing costs, and it is largely used in the same manner today, although for a broader group of financial products.

For instance, many banks use LIBOR to set prices on derivatives, the complicated financial instruments tied to commodities, interest rates, currencies and other assets.

Can you clarify how it is calculated?

Sure. It is Thomson Reuters which calculates and publishes the rate on behalf of the British Bankers' Association (BBA). Please note that the LIBOR interest rates are not based on any fixed calculation.

What happens is that, on every working day and usually at around 11 am London time, a panel of contributor banks (usually 11 to 18 large, international banks such as Citigroup, JP Morgan Chase, Bank of America, Barclays, UBS, HSBC and others) informs Thomson Reuters the interest rate for each maturity of time-frames at which they expect to be able to raise a substantial loan in the interbank money market at that moment. Obviously, the rates differ from bank to bank.

Thomson Reuters collects these rates from all panel banks. They then eliminate the highest and lowest 25 per cent of values. For the remaining 50 per cent ‘mid values’ (as the highest and lowest 25 per cent are eliminated), they calculate an average to produce the official LIBOR rate.

As said, the calculations are performed by Thomson Reuters and the process is overseen by BBA.

Given that it acts like a benchmark rate, somebody should regulate them, right?

Yes, LIBOR is governed by the International Exchange (ICE) Benchmark Administration.

Oh! Is not BBA the regulating body?

Good catch. Let me explain… Until January 31, 2014, the LIBOR was known as the BBA LIBOR (for British Banker’s Association). However, BBA LIBOR came under fire when few prominent panel Banks were investigated for manipulating the benchmark rate by submitting false borrowing rates to the British Banker’s Association.

This scam shook the credibility of LIBOR in the financial markets. Soon after this, the governance was transferred to the ICE Benchmark Administration, and the trust in LIBOR is being restored as we speak…

Therefore, today the BBA LIBOR is called ICE LIBOR! LIBOR has endured many controversies and continues to do so, and whether it is BBA or ICE administered, the LIBOR continues to play an important role in the credit market.

To sum up, the daily borrowing rates are still the most important numbers in finance...which the business world, at least for the moment, cannot live without!

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