What is London InterBank Offered Rate (LIBOR)?
The London InterBank Offered Rate (LIBOR) is an interest rate that large banks use as a benchmark when lending each other money.
🤔 Understanding LIBOR
The London InterBank Offered Rate (LIBOR) is an interest rate, used for loans between banks, that is calculated daily by the Intercontinental Exchange (ICE). ICE uses five currencies to determine this rate: the U.S. dollar, the euro, the pound, the Japanese yen, and the Swiss franc. It also uses seven different maturities ranging from overnight to 12 months. The result is 35 LIBOR rates that ICE publishes daily. When large banks lend each other money, they usually use LIBOR as the benchmark interest rate for the loan. Banks also use LIBOR as a basis for rates on consumer loans, such as mortgages and car loans. Because of concerns about inaccuracies, LIBOR will be phased out by the end of 2021.
Susan is taking out a 30-year floating rate mortgage. Suppose Susan’s local bank, where she is applying for the mortgage, uses LIBOR to determine Susan’s initial interest rate. The next time Susan’s bank goes to adjust her interest rate, they’ll check LIBOR and use that rate to set Susan’s new interest rate.
LIBOR is like a thermostat…
Every morning the Intercontinental Exchange (ICE) sets the thermostat (LIBOR) at a number they determine based on several different factors. As a result, the temperature (the benchmark interest rate) either goes up or down accordingly.
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What is the history of LIBOR?
The British Bankers’ Association (BBA) set up LIBOR in 1984. More interest rate based products were coming onto the market, and it became clear that a benchmark interest rate was necessary. More specifically, there were more options-trading taking place. An option is a financial product that gives someone the option of taking a particular type of action — That action is usually to buy or sell an underlying security. The success of options depends heavily on the interest rate since that’s often what determines whether or not the option is profitable.
LIBOR doesn’t look the same today as it did in 1984. First, in 2014 LIBOR moved from BBA to the Intercontinental Exchange (ICE), which took over the BBA. They have used different currencies over the years to calculate LIBOR. For example, the euro did not exist in 1984 when LIBOR was created (the European Union didn’t adopt it until 1999). That currency was added later. LIBOR has also undergone great scrutiny over the past decade and will be phased out by the end of 2021.
How is LIBOR calculated?
The Intercontinental Exchange (ICE) calculates and publishes LIBOR each business day under the regulation of the Financial Conduct Authority. To calculate LIBOR, ICE asks a panel of banks what interest rate they would expect to get when borrowing money from another bank. The panel is made up by large, international banks that are chosen annually.
They ask for interest rates in five different currencies (the dollar, the euro, the pound, the yen, and the franc), and seven different interest rates (for loans of different maturities). The banks send an interest rate for each of the maturities. From this information, ICE determines 35 different interest rates, which are a combination of the maturities and currencies they use.
There is a three-level method they use to determine LIBOR. First, they take a volume-weighted average price of the rates the banks provided. They also take an average of rates from actual transactions from that bank. In the second level, they take transaction-derived data from banks that don’t have enough transactions to complete the first level. Finally, if a bank can’t comply with either of the first two levels, it merely states the rate they believe they would use. This three-level approach was implemented in 2018 to improve accuracy.
The rate that those in the finance industry most often quote (the one they often refer to as the current LIBOR rate) is the U.S. dollar rate for a three-month maturity. For reference, here is what the U.S. dollar rates looked like on January 15, 2020:
- Overnight: 1.53%
- One week: 1.56%
- One month: 1.67%
- Two months: 1.79%
- Three months: 1.84%
- Six months: 1.87%
- Twelve months: 1.95%
What is the difference between LIBOR and the Federal Reserve rate?
You may not have heard of LIBOR, but chances are good you’ve heard of the Federal Reserve rate, which is the interest rate set by the U.S. Federal Reserve (aka the central bank in the United States). These are the two most commonly quoted interest rates, at least in the United States. But what’s the difference?
LIBOR is a rate that is used worldwide, though it’s set in London. It takes into account information from several different currencies and several different maturities. ICE sets LIBOR daily. Financial institutions often use LIBOR in the case of short-term loans, investments, and floating rate financial products.
The rate set by the Federal Reserve (the federal funds rate) is specific to the United States. They might only change this rate a handful of times per year, rather than the daily change of LIBOR.
The Federal Reserve uses the federal funds rate to manage the United States economy. If the economy is growing too slowly, the Federal Reserve might lower the interest rate to make it easier for people to get loans to get people to spend money. If the economy is growing too quickly, and we’re at risk of rapid inflation, the Federal Reserve might increase the interest rate to slow spending a bit and discourage people from taking out loans.
Banks in the United States use the Federal Reserve rate often, especially in the case of long-term fixed-rate loans like mortgages.
What are the uses of LIBOR?
Whether you’ve heard of it or not, LIBOR is something that has probably affected your life (your financial life, more specifically). It is responsible for the rate of trillions of dollars of financial products around the world.
Lending institutions use LIBOR to determine your rate for all kinds of loans and credit. They often use LIBOR for products like adjustable-rate mortgages and student loans. But they also might use LIBOR to determine the interest rate on your regular loans and credit cards. To determine the rate for your loan, banks often use LIBOR, plus a certain percent.
Plenty of other financial products use LIBOR. For example, floating-rate certificates of deposit very well might have an interest rate based on LIBOR. Additionally, hybrid products (those that use more than one financial instrument, like equity and debt) often use LIBOR. One example of such a product would be a collateralized debt obligation, which is when a bank packages a bunch of individual loans into a single product and sells it off to investors.
One of the most common uses of LIBOR is for the sale of derivatives such as interest rate swaps, which is when two financial institutions agree to trade interest rates. In these situations, institutions are trading a floating interest rate for a fixed interest rate. A company might do this to hedge its risk against an interest rate increase, which would increase its interest payments. LIBOR is what typically determines these floating interest rates.
Why is LIBOR being phased out?
Despite its importance in the lending world, LIBOR will be phased out by the end of 2021. According to the United Kingdom Financial Conduct Authority (FCA), they’re phasing LIBOR out because it doesn’t reflect real transactions anymore.
The Intercontinental Exchange (ICE) uses the interest rates banks use to lend money to each other. But the business of banks borrowing from one another has not been prevalent since before the financial crisis.
LIBOR has also had its fair share of scandal over the past decade, which some speculate could have been a contributing factor (it may have lost some of its credibility). Because of the way ICE determined LIBOR, it was quite easy to manipulate.
Banks report interest rates to the ICE, and ICE uses that information to set LIBOR. There have been complaints of banks reporting inaccurate information, either to make it seem like business was better than it was or to make a profit by reporting more generous rates than were actually taking place.
This false reporting was especially prevalent during the financial crisis in 2008. And since so few banks provide rates for LIBOR, it’s easy for just a couple of banks fudging numbers to make a difference. Since 2012, banks in the United States, the United Kingdom, and the European Union have paid over $9B in fines for these behaviors, and some investors involved went to prison.
In 2014, the Federal Reserve formed the Alternative Reference Rate Committee (ARRC). They tasked this committee with identifying an alternative to LIBOR for the benchmark interest rate. In 2017, the committee recommended the Secured Overnight Financing Rate (SOFR) to take the place of LIBOR. SOFR is an interest rate that represents overnight, risk-free transactions. Financial institutions often use this rate in the money market. Some financial institutions are already using SOFR.
Many financial institutions are still using LIBOR, though. In fact, they are using LIBOR on transactions for financial products that will undoubtedly live past the end of 2021. When LIBOR is gone, those banks will have to figure out what to do with those products. Financial institutions will likely face some hefty administrative costs for the work of changing their contracts and computer systems to a new benchmark.
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