Menu
sharewise sharewise
Log in
Sign up
Log in
Sign up
Microsoft strongly encourages users to switch to a different browser than Internet Explorer as it no longer meets modern web and security standards. Therefore we cannot guarantee that our site fully works in Internet Explorer. You can use Chrome or Firefox instead.

Dictionary

Understanding the London Inter-Bank Offered Rate (LIBOR)

When diving deep into the world of finance, one will undoubtedly come across the term London Inter-Bank Offered Rate, commonly known as LIBOR. Many might be familiar with the basics, but this article aims to provide an in-depth comprehension, delving into its key components, purposes, and the controversies surrounding it.

What is LIBOR?

To put it simply, LIBOR is a benchmark interest rate at which major banks, on a global scale, lend money to each other on the international interbank market. It serves as a reference point in the pricing of trillions of dollars' worth of financial products, ranging from mortgages and student loans to complex derivatives. LIBOR is determined daily by the Intercontinental Exchange (ICE), considering the rates at which banks are willing to lend to each other.

Why is LIBOR Important?

LIBOR's significance in the financial world can be summarized in three primary reasons:

  1. Benchmark for financial instruments: LIBOR is extensively used as a benchmark interest rate to determine terms and pricing in various financial instruments, such as loans, fixed-income securities, interest rate derivatives, and mortgage-backed securities.

  2. Indicator of market condition: The interest rate landscape constantly evolves, and LIBOR helps its users to gauge the overall health of the financial market. When LIBOR is on the rise, it may signify an increase in borrowing costs, which points to a tightening of credit availability. Conversely, a drop in LIBOR signals lower borrowing costs and easier access to credit.

  3. Component of risk management models: Because LIBOR has played such a central role in the pricing of financial products, it is a fundamental input for various risk management models. Financial companies and investors use these models to assess potential risks to their portfolios and make better-informed decisions.

How is LIBOR Calculated?

Every business day, the panel banks - global financial institutions appointed by ICE - submit the interest rates they believe they would be charged if they borrowed funds from other banks. These submissions are made in five currencies, namely the US Dollar, Euro, British Pound Sterling, Japanese Yen, and Swiss Franc, and for seven different tenors, spanning overnight to twelve months.

After receiving all submissions, ICE calculates LIBOR by following these steps:

  1. Arrange the submitted rates in ascending order.
  2. Eliminate the highest and lowest 25% of submitted rates (upper and lower quartiles).
  3. Calculate the average of the remaining rates in the middle 50%.
  4. Publish LIBOR rates for five currencies and seven tenors.

This average rate, developed under the process, is taken as the LIBOR rate for that specific currency and tenor on that day.

LIBOR's Controversy and Transition

Despite its widespread adoption and importance in the financial system, LIBOR has faced criticism and controversy, particularly due to a rate-rigging scandal that emerged in 2012. It was discovered that certain banks were manipulating LIBOR submissions to either improve their own trading positions or create a false depiction of their creditworthiness.

This egregious misconduct led to several banks facing hefty fines, legal consequences, and substantial damage to their reputations. Furthermore, this episode revealed the inherent flaws in the method by which LIBOR was determined, spurring regulators to seek alternatives with a more transparent and reliable infrastructure.

As a result, the United Kingdom's Financial Conduct Authority (FCA) announced in 2017 that LIBOR would cease to operate by the end of 2021. In its place, alternative risk-free rates (RFRs) had been developed to guide financial markets going forward. Some of the leading RFRs include the United States' Secured Overnight Financing Rate (SOFR), the United Kingdom's Sterling Overnight Index Average (SONIA), and the Euro Short-Term Rate (€STR).

Key Takeaways

In summary, the LIBOR can be described as the beating heart of the international financial system, determining the interest rates applicable for a multitude of financial products while being a vital indicator of market conditions. It's also central to risk management strategies, and its daily calculation involves a panel of major banks submitting interest rates for five currencies and seven tenors.

However, following the revelation of a rate-rigging scandal in 2012, the financial landscape has begun shifting away from LIBOR, instead embracing alternative risk-free rates as the new foundation for measuring and managing financial transactions. As LIBOR makes its exit, the days of this influential benchmark are numbered, but its legacy within the financial world will never be forgotten.

Feedback