The London Interbank Offered Rate (LIBOR) plays a key role in the global currency economy and major historical currency events. It makes sense because it is the benchmark rate for many loans and derivative products. Although the rates are based on trading carried out in London, the implications are global.
LIBOR acts as the effective floor for lending rates, with commercial and personal borrowing rates all based on its level. The LIBOR rate will also act as a ceiling for short-term deposit rates.
What is LIBOR and How is it Calculated
The London Interbank Offered Rate (LIBOR) is a benchmark interest rate that sets the base level for commercial lending rates in the UK. To calculate LIBOR, a panel of large and active banks in London provide daily estimates of the interest rates at which they could borrow funds from other banks in the wholesale money market. The banks submit their estimates based on the rates at which they have traded in the market and their own judgment about current market conditions. The Intercontinental Exchange (ICE) Benchmark Administration, which is responsible for administering LIBOR, compiles and averages the submissions to produce the benchmark rate.
The benchmark rate is calculated by taking a trimmed arithmetic mean of the submissions. The highest and lowest 25% of submissions are excluded, and the remaining submissions are averaged to produce the benchmark rate. The rate is published each day in seven different maturities, ranging from overnight to 12 months, and is used in various financial contracts and instruments around the world.
The overnight rate is typically the lowest, as the probability of repayment is highest for such a short period of time. However, as the duration of the loan period lengthens, the risk premium also increases, and banks will charge higher interest rates. This results in an inverse pyramid of rates, with the LIBOR rate as the base.
Banks use the LIBOR rate as a benchmark for setting the interest rates they charge on loans to their customers. The rate on short-term deposits will be lower than the LIBOR rate, as banks need to profit from lending and holding deposits.
The LIBOR rate is also a reference rate for various derivative products, such as forward rate agreements, futures, interest rate swaps, and swaptions. It is estimated that over $350 trillion in financial products have rates that are tied to the LIBOR rate.
LIBOR rates are also critical links between central and commercial banks. The Bank of England and other central banks set benchmark interest rates, such as the overnight rate, which serve as a floor for LIBOR rates. However, if the central bank increases the base rate, LIBOR rates will also increase, which will have a direct impact in the broader economy.
It is worth noting that changes in central bank rates are the dominant influence on LIBOR rates, but other factors such as the level of confidence and fear in the global financial system, can also impact the rate. For example, during the 2008 financial crisis, LIBOR rates moved even if official bank rates did not change, reflecting the increased uncertainty and risk in the market.
The currencies for which Libor rates are calculated are:
The period rates are currently set for are:
- 1 week
- 1 month
- 2 months
- 3 months
- 6 months
- 12 months
Changes in LIBOR rates also have a crucial effect at the retail level and towards business fx transactions which often involved derivatives. When commercial banks make loans, the interest rate charged to customers is based on numerous factors such as competitive pressures and individual credit-rating scores for prospective borrowers.
In effect, banks will look to determine the number of margins that need to be applied to individual loans. The overall interest rate charged will be the LIBOR rate plus the margin that is applied.
For example, if LIBOR rates are at 1.0% and a commercial bank looks to apply a 3.0% margin, there will be an overall interest rate on the consumer loan of 4.0%.
If, therefore, there is an increase in the LIBOR rate to 2.0%, there will also be upward pressure on overall interest rates. If the full increase in passed on, there would be an increase in the overall interest rate to 5.0%, although the bank may look to lower its margins which would lessen the impact slightly.
LIBOR rates also have an important impact on adjustable-rate mortgages (ARMs) and sub-prime mortgages. This is in contrast to the fixed-rate mortgages which are set by reference to bond-market yields.
Interest rates on municipal loans are also set by reference to LIBOR rates. Any public institution with substantial borrowings will, therefore, pay higher interest costs if the LIBOR rate increases and this will, therefore, also tend to reduce the number of funds available to spend on government services.
Interest rates on savings accounts are also set with reference to LIBOR rates. If LIBOR rates rise, financial companies will raise interest rates on savings. Conversely, the rate of savings accounts will decline if LIBOR rates fall.
The LIBOR Scandal
It was the calculation method for LIBOR which gave rise to the scandal with a particular focus on the financial crisis in the 2008/09 period, although evidence suggests that the practise had been going on since at least 1991. This is one of the biggest UK bank scandals of all times. It also made the LIBOR rate “devalue” in the eyes of investors since then.
There was an important risk of collusion between individual banks setting the rate. The banks had a strong interest in either setting rates too low or too high to ease financial strains on the bank depending on whether they needed to borrow substantial amounts of funds daily.
Individual traders at these banks would look to do favours for each other by submitting a rate that was either too low or too high with the expectation that the favour would be returned at some point in the future.
The LIBOR rates were, therefore, effectively set at the wrong level and this would have had an important impact through the lending chain. If rates were set to high, then this would tend to put upward pressure on commercial lending rates and it is also possible that loans for personal lending would be marginally higher as a result.
However, the overall impact on the personal sector was limited given that relatively very small changes in LIBOR rates will have only a marginal impact on overall rates for consumer loans and mortgages.
There was much more important impact in areas of corporate lending and financial derivatives, especially given the number of funds borrowed through these channels. There would be a substantial impact on companies with very high borrowing needs.
LIBOR Is Being Replaced
In the US
LIBOR was a key benchmark for setting interest rates on loans and debt for more than 40 years. However, it is being replaced by the Secured Overnight Financing Rate (SOFR), which is considered more accurate and secure. The Federal Reserve Board implemented the Adjustable Interest Rate (LIBOR) Act, which identifies benchmark rates based on SOFR that will replace LIBOR after June 30, 2023. Those with adjustable-rate loans should confirm whether their loan is based on LIBOR and determine the index to which the lender will switch. Without a provision in the loan documents, SOFR will replace LIBOR.
In the UK
Since the global financial crisis, activity in the markets that LIBOR measures has decreased, and the low volume of underlying transactions means that LIBOR is no longer sustainable. Publication of 24 of the 35 LIBOR settings ceased from 1 January 2022. Risk-free rates (RFRs), including the Sterling Overnight Index Average (SONIA) benchmark, are available as robust alternatives to LIBOR.
The Bank of England has worked with the Financial Conduct Authority and market participants to support a smooth transition to these alternatives. The industry-led Working Group on Sterling Risk-Free Reference Rates provides guidance and support for financial and non-financial firms to help them with the transition, and the Bank of England and the FCA participate in this group. The 1- and 6-month sterling LIBOR will continue on a synthetic basis until end-March 2023, and the 3-month sterling LIBOR will continue on a synthetic basis until end-March 2024. Five US dollar LIBOR settings will continue to be calculated until end-June 2023, although its use for new business has been restricted since end-2021.
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