Libor, short for the London Interbank Offered Rate, is a benchmark interest rate at which global banks offer to lend unsecured funds to one another in the international interbank market. This rate is calculated and published daily and serves as a critical reference for a wide array of financial instruments.
Definition of Libor
Libor is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. Unlike the London Interbank Bid Rate (Libid), which represents the rate at which banks are willing to borrow, Libor includes a profit margin that banks charge each other for providing loans.
Key Characteristics
- Multi-Currency and Multi-Tenor: Libor is published for five currencies (USD, EUR, GBP, JPY, CHF) and for seven different borrowing periods (overnight, one week, and 1, 2, 3, 6, and 12 months).
- Daily Calculation: Each day, a panel of leading banks submits their borrowing rates, which are subsequently averaged after removing the highest and lowest quartile rates to eliminate outliers.
- Reference Rate: Libor serves as the foundational benchmark for pricing various financial products including derivatives, mortgages, and student loans.
Historical Context
Libor was officially introduced in 1986 by the British Bankers’ Association (BBA) to standardize the calculation and broader financial practices. Over time, it gained prominence and became intertwined with a vast array of financial instruments impacting global markets.
Evolution and Reform
Due to the LIBOR scandal in the early 2010s, which revealed the manipulation of submission rates by some banks, significant reforms were undertaken. The administration of Libor was transferred to the Intercontinental Exchange Benchmark Administration (IBA) in 2014 to enhance reliability and transparency.
Applicability
Libor is extensively used across various facets of the financial industry:
- Loan Rates: Serves as a reference for setting the interest rates on personal and corporate loans.
- Derivatives: Key benchmarking rate for interest rate swaps, futures, and other complex financial instruments.
- Mortgages and Credit: Influences adjustable-rate mortgages (ARMs) and floating rate notes (FRNs).
Comparisons
- Libor vs. Libid: Libor (offered rate) is typically higher than Libid (bid rate) due to the additional profit margin banks charge.
- Libor vs. SOFR: The Secured Overnight Financing Rate (SOFR) is emerging as an alternative to Libor, particularly in the United States, due to its reliance on actual transaction data.
Related Terms
- Libid: London Interbank Bid Rate - the rate at which banks are willing to borrow.
- Euribor: Euro Interbank Offered Rate, similar to Libor but specific to the Eurozone.
- SOFR: The Secured Overnight Financing Rate, a replacement rate for Libor in the U.S.
Frequently Asked Questions (FAQs)
What Are the Consequences of Libor Phase-Out?
The planned phase-out of Libor by 2023 necessitates transitioning to alternative reference rates like SOFR in the U.S., requiring significant adjustments in financial contracts and systems globally.
Why Was Libor Subject to Manipulation?
The rate was more susceptible to manipulation because it was based on self-reported estimates from banks rather than actual transaction data, creating potential conflicts of interest.
How Does the Calculation of Libor Work?
A panel of major global banks provides daily estimates of the rate at which they would lend to each other. The highest and lowest quartiles are excluded, and the remaining rates are averaged to publish the daily Libor.
References
- “Understanding Libor: What is it, and why does it matter?” - Financial Times.
- “The Evolution of Libor: Past, Present, and Future” - Harvard Business Review.
- “Libor Transition: The Starting Line” - International Monetary Fund (IMF) Working Paper.
Summary
Libor is a pivotal reference rate in the global financial system, guiding the pricing of trillions of dollars in financial products. Despite its historical significance, it is being phased out due to issues of reliability and manipulation scandals, paving the way for new alternative rates like SOFR. Understanding Libor’s mechanisms, applications, and evolution is key to navigating contemporary financial markets.
