The Libor, also known as the London InterBank Offered Rate, is an interest rate that serves as the benchmark for the interest rate that major global banks offer to one another. Although London seems like a world away from the United States, the Libor rate directly influences the world economy, both in the banking sector and for consumer loans.
- What Is the London InterBank Offered Rate?
- How Is Libor Calculated?
- Does Libor Change Daily?
- Why Does the Libor Rate Exist?
- The Libor’s Significance on Interest Rates Today
- Why Might the Libor Be Negative?
- What Does Libor Mean for Loans?
The Libor is the interest rate banks around the world use when charging each other for short-term loans. These loans only last anywhere between overnight, one week, a month, three months and up to one year. Because world banks work with the London InterBank Offered Rate, rates are published every morning in five currencies:
- British pound sterling (GBP)
- Euro (EUR)
- Japanese yen (JPY)
- Swiss franc (CHF)
- U.S. dollar (USD)
Libor suffered a scandal after the 2008 financial crisis. British and U.S. authorities uncovered that traders managed to manipulate it and make a profit. The benchmark is set to be decommissioned by the end of 2021, but there are delays in the phase-out due to the volume of global contracts — $340 trillion worth. The current Libor is now known as the ICE Libor.
Each morning shortly before 11 a.m. Greenwich Mean Time, the ICE Benchmark Administration, or IBA, hosts a panel of 11 to 16 international banks representing the five currencies. Representatives from the Federal Reserve, the Bank of England and the Swiss National Bank attend as observers. The contributing banks must respond to the question: “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 a.m.?”
The banks submit their confidential answers. To calculate the day’s Libor rate, the IBA uses the Libor Methodology to remove the lowest and highest values and average the rest. IBA publishes the rates for the day at 11:55 a.m. London time. The current Libor rate list can be seen on websites such as:
Yes, the Libor can change daily because the international banking panel submits answers on a daily basis. The attending banks might also change from day to day, as there are 20 banks available to participate on the panel.
Financial institutions often loan each other money for temporary liquidity. The Libor rate was created to act as the average interest rate benchmark for these short-term loans among leading banks in London, and it’s the dominant estimate for interest rates in the financial market worldwide.
The British Bankers Association, or BBA, was formally charged with the responsibility of calculating Libor rates. After the scandal in 2008, the ICE Benchmark Administration (IBA) took over to calculate and publish rates in five currencies and ten borrowing periods:
- Overnight/Spot Next
- One Week
- One Month
- Two Months
- Three Months
- Six Months
- Twelve Months
The rates serve as guidelines to banks when they set interest rates for short-term credit-based products like adjustable-rate loans, mortgages and credit cards.
U.S. interest rates rely on the current Libor rate to assess how much of an increase or decrease will go into effect for borrowers. For example, for someone who has an adjustable-rate loan, the amount of the current Libor rate will influence what their new rate will look like upon each rate renewal period.
Typically, banks add a point or two to the Libor rate as their margin, before passing it on to the consumer. It is only slightly higher than the Federal Reserve’s target rate, in most cases.
Rises in the Libor interest rate also have a general effect on the economy, reducing liquidity between banks and making all types of consumer loans more expensive, thereby slowing economic growth.
For instance, when the House of Representatives rejected the Bank Bailout Bill, this circumstance drove the Libor up precipitously — from 2.95% to 6.88%. As a result, banks began to hoard cash, and liquidity between banks suffered even as banks’ stock shares rose. Banks, therefore, began scrambling for short-term funds, paying up to 11% for billions of dollars in overnight funds from the European Central bank.
The 2008 financial crisis caused banks to slow down or completely stop lending. Central banks decided to cut benchmark lending rates below zero to kick-start lending and reinvigorate economic growth. The new concept meant banks would have to “pay” to park their money in the hopes of getting them exchanging again.
Why Do Negative Interest Rates Exist?
Banks that hang on to money cause liquidity issues and limit the number of loan products available. Negative interest rates might encourage banks to lend money to other banks instead of paying to keep it at the central bank.
Despite occurrences like the 2008 scandal and the benchmark’s eventual phase-out, the U.S. banking industry continues to lean heavily on the rate to guide its interest rates today. Libor acts as the benchmark for consumer mortgages, currency swaps and adjustable-rate lending such as credit cards and interest-only mortgages.
The current Libor rate could directly affect anyone with an adjustable-rate mortgage. A rise in the rate means your monthly payments will be higher. The same issue comes up if you’re paying off your credit cards. That’s because your credit card’s interest rate is variable and based on the Libor.
A rising Libor rate could affect the economy as a whole. A high Libor means borrowing becomes more expensive for companies needing a loan to expand or finance their business operations. Companies that can’t borrow at a reasonable rate might cut back on expenditures and lay off workers. Unemployed individuals would spend less, creating a chain reaction that could lead to a recession.
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