Firstly, let’s look how important Libor actually is.
Whist the London Interbank Offer Rate (Libor) might mean little to the average man on the street it’s actually the most used interest rate in the world. Market observers estimate that around $500 trillion is tied to the Libor. Considering that the US budget deficit is around $14 trillion, this gives you some idea of the impact of Libor. And its impact affects almost everyone – investors, savers, and borrowers – for the Libor is the rate at which banks lend to each other on short term money, from overnight to the often quoted 1 year libor.
The libor rate is used to calculate not only commercial borrowing rates, but is also used to calculate the prices many investment and financial trading products. A small change in libor can mean a large difference in the pricing of some derivatives products.
Libor is fixed at 11am London time each morning, and remains fixed for 24 hours.
When you invest, the price of the asset in which you wish to invest may be affected by the libor rate. If you are placing cash on short term deposit, or seeking a mortgage, the rates which are applied to you will be determined by reference to libor.
Libor Rate History
As the international markets increased in scope and size, banks increasingly loaned money to each other. They also began to trade new instruments, such as swaps and interest rate forwards, in response to short term financing requirements.
In the mid-1980s this trade had increased to such a size that the British Bankers Association (BBA) and the Bank of England sought to standardize the market. Several working parties thrashed out a plan to produce a standard rate for the calculation of interest rate swaps, and these BBAIRS as they were known became standard practice.
This included the fixing of interest settlement rates, the predecessor of libor. Libor fixings officially started on the 1st January 1986.
The libor rate is fixed by reference to the rate at which major banks expect to be able to borrow funds in reasonable size from each other. 18 banks are asked this question, and the top and bottom four results are discarded, the average of the remaining 10 becoming the official libor at that fixing.
There are 15 different maturity dates through to 12 months on the libor rates, though the most commonly quoted are the overnight, the three month, and the 1 year libor.
Products whose prices are calculated with reference to libor include interest rate futures, swaps, floating rate notes, syndicated loans, variable rate mortgages, collateralized mortgages and debt, and forward rate agreements.
To give some idea of the impact of libor on a borrower in the United States, around 80% of subprime mortgages are indexed to libor, along with nearly 50% of prime adjustable; rate mortgages.
The Libor Crisis
In late February 2012, the US Department of Justice launched investigations into libor abuse dating back to 2008. Allegations centered on possible rate fixing so that derivatives traders could advantage from the libor rate set.
One trader reckoned that for every 001% that libor was moved, profit was impacted by around $2 million at his bank alone. When banking bonuses rely on profits, such moves make a big difference.
The ensuing result that libor was rigged around that time led to the fining of Barclays, and several other banks are now under investigation. However, some are questioning why it took so long for investigations to begin and judgments to be made. In 2008, a trader at Barclays had reported to the Fed that he believed libor was being underreported.
The Fed wrote to authorities, including the UK authorities, informing them of this manipulation and ways in which it felt the system could be tightened. The governor of the Bank of England, Mervyn King, in November 2008, described libor by explaining it thus to the UK Parliament: “It is in many ways the rate at which banks do not lend to each other, … it is not a rate at which anyone is actually borrowing.”
Perhaps it was the IMF’s response that caused the delay to any action. In October 2008, it said that it saw very little, if any problem. In its Global Financial Stability Review it stated that “Although the integrity of the U.S. dollar Libor-fixing process has been questioned by some market participants and the financial press, it appears that U.S. dollar Libor remains an accurate measure of a typical creditworthy bank’s marginal cost of unsecured U.S. dollar term funding.”
So, the result is that now, four years after the alleged events, Barclays have been heavily fined, several other banks have been implicated and are being investigated, and in September 2012 Central Bankers will be discussing whether Libor can be repaired, or whether it should be replaced by another system of international rates. In the meantime, the world relies on libor.