The Libor, also known as the London InterBank Offered Rate, is an interest rate which serves as the benchmark for the interest rate that banks offer to one another. While London seems like a world away from the United States, the Libor rate directly influences the world economy, both in the banking sector and as a benchmark for consumer loans.
Why Does the Libor Rate Exist?
Financial institutions often loan each other money for temporary liquidity. As such, the Libor rate was created to act as the average interest rate benchmark for short-term loans among leading banks in London, and is the dominant estimate for interest rates in the financial market worldwide.
The British Bankers Association (BBA) is charged with the responsibility of calculating Libor rates for ten currencies and 15 varieties of borrowing periods (e.g. a one month loan versus a one year loan), then the BBA publishes the Libor rate each morning. This figure serves as a guideline to banks when they set interest rates today for short-term credit-based products, like adjustable-rate loans, mortgages and credit cards.
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.
The Libor’s Significance on Interest Rates Today
U.S. interest rates today rely on the Libor to assess how much of an increase or decrease will go into effect for borrowers. For example, if you have an adjustable-rate loan, the amount of the current Libor rate will influence what your new rate will look like upon each rate renewal period.
Rises in the Libor interest rate also has 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. At that time, banks began scrambling for short-term funds, paying up to 11 percent for billions of dollars in overnight funds from the European Central bank.
Despite occurrences like the incident described above, the banking industry in the United States continues to lean heavily on the Libor rate to guide its interest rates today.