Interbank Rate: Interest Rate Between Banks

The Interbank Rate, commonly referred to as LIBOR (London Interbank Offered Rate), is the rate at which banks lend to one another in the international interbank market.

The Interbank Rate, often synonymous with the London Interbank Offered Rate (LIBOR), is the interest rate at which banks lend to one another in the international interbank market. It is a crucial benchmark in the finance industry for setting the rates of various financial products and instruments, including loans, mortgages, and derivative contracts.

Understanding LIBOR

Definition and Calculation

LIBOR stands for the London Interbank Offered Rate and represents the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. This rate is calculated for different periods (e.g., one month, three months, six months) and for multiple currencies, such as USD, EUR, GBP, JPY.

LIBOR is computed every business day by the Intercontinental Exchange (ICE) and is based on submissions by a panel of major global banks. The rates submitted by these banks are averaged to determine the daily LIBOR rate for each currency and tenor.

Types and Tenors of LIBOR

LIBOR rates are provided for various durations, known as tenors:

• Overnight
• One week
• One month
• Three months
• Six months
• One year

These rates are published for several key currencies:

• USD LIBOR
• EUR LIBOR
• GBP LIBOR
• JPY LIBOR
• CHF LIBOR

Significance of the Interbank Rate

Financial Products

LIBOR is instrumental in determining the interest rates for a wide array of financial products:

• Adjustable-rate mortgages (ARMs)
• Credit card interest rates
• Student loans
• Savings accounts
• Derivatives, such as interest rate swaps and futures contracts

Comparison with Other Rates

Prime Rate

The Prime Rate is the interest rate that commercial banks charge their most creditworthy customers. Unlike LIBOR, which is an interbank rate, the Prime Rate is primarily influenced by the Federal Reserve’s policy.

Federal Funds Rate

The Federal Funds Rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight on an uncollateralized basis. This rate is a key tool of the U.S. Federal Reserve in implementing monetary policy.

Historical Context and Transition

History of LIBOR

LIBOR was established in 1986 by the British Bankers’ Association (BBA) as a way to standardize the rates banks charge each other. Over time, it became the dominant global benchmark interest rate.

LIBOR Scandal and Reforms

In 2012, it was revealed that some banks had manipulated LIBOR submissions to profit from trading positions or to appear more creditworthy than they were. This led to significant reforms and the transition from BBA to ICE for administering LIBOR.

Transition to Alternative Reference Rates (ARRs)

Due to the manipulation scandal and declining use of interbank unsecured loans, financial authorities decided to phase out LIBOR by the end of 2021, transitioning to more reliable benchmarks like:

• SOFR (Secured Overnight Financing Rate) in the United States
• SONIA (Sterling Overnight Index Average) in the United Kingdom
• ESTR (Euro Short-Term Rate) in the Eurozone

Applicability and Use Cases

LIBOR still influences a variety of financial instruments and contracts even during the transition phase. Financial professionals and institutions need to adapt to new benchmarks while ensuring that existing contracts and risk management strategies comply with the ongoing changes.

FAQs

What is the LIBOR Transition?

The LIBOR transition refers to the move towards replacing LIBOR with more robust alternative reference rates by the end of 2021. This transition is crucial to prevent reliance on a flawed benchmark and to promote financial stability.

How does LIBOR impact the average consumer?

LIBOR affects consumers primarily through loans and mortgages. A fluctuation in LIBOR can lead to changes in interest rates for adjustable-rate loans and credit products, impacting monthly payments and overall loan costs.

What are alternative reference rates (ARRs)?

Alternative Reference Rates (ARRs) are new benchmark rates that are being adopted to replace LIBOR. These rates are generally based on actual transaction data and are considered more robust and reliable. Examples include SOFR, SONIA, and ESTR.

Summary

The Interbank Rate, commonly known as the London Interbank Offered Rate (LIBOR), is a foundational element in the global financial system, impacting a myriad of financial instruments and transactions. With its historic significance and its recent transition to alternative reference rates, understanding LIBOR remains essential for professionals in finance and banking.

References

• ICE Benchmark Administration. Understanding LIBOR. Retrieved from ICE LIBOR.
• Financial Conduct Authority. LIBOR Transition. Retrieved from FCA LIBOR Transition.
• Federal Reserve Bank of New York. Secured Overnight Financing Rate. Retrieved from SOFR Overview.

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