LIBOR, or the London Interbank Offered Rate, is the rate at which large banks are able to borrow funds from other banks, published daily by the British Bankers Association. LIBOR is an integral part of many rate calculations and derivatives contracts, which are often expressed as LIBOR + X%.
Q. So this is one of the most used terms in the entire financial world, and yet how it works is a bit mysterious… as demonstrated by all the problems over at Barclay’s right now. Let’s start here: exactly what is LIBOR?
A. The London Interbank Offered Rate, probably the most basic banking benchmark in the world. It’s published every day by the British Bankers Association, and it represents the average rate that some very large banks estimate they would have to pay if borrowing from other banks. So, each morning around 11am, the BBA publishes LIBOR for loans of various terms: one month, three months, six months, a year, etc., and in different currencies. Then, huge numbers of institutions, from credit card companies to worldwide banks to mortgage companies, base their own floating rates off the relevant number. Credit card companies, for example, might set their rates by the formula: LIBOR + 12%; commercial loans might be offered at LIBOR+4. Some $10 trillion of loans are fixed off LIBOR.
Q. And its a key element of many derivatives contracts, too, right?
A. Oh, yes. Actually, that’s how it was invented: it started as a way to facilliate interest rates swaps in the 80s (frightening: I was a lawyer drafting this stuff up at the time and recall the need for standardization). Now, some $350 trillion in notional amount of derivatives is tied to LIBOR.
Q. So, turning to LIBOR-gate, Barclays has falsifying their LIBOR estimates and paid a big fine. What was going on?
A. Looks like two things, at least. First, a form of insider trading, essentially. If you and your pals are setting the rates, its not surprising you can make a few bucks on interest rate swaps. But it also looks like they were submitting intentionally low LIBOR numbers because people were concerned about the health of the bank: if it had to pay high rates to borrow, maybe it was unhealthy.
Q. And all this arises because LIBOR is not actually generated off of trading data, but just the banks’ estimates of what they’d have to pay to borrow from other banks?
A. Right, that’s the key problem: the rates were easy to manipulate. The system needs adjusting so that can’t happen in the future. This rate is just too important to be subject to getting rigged by a few traders at a few banks… after all, people’s mortgage and credit card rates are at stake, not just interest rate swap contracts between big boys.