The London Interbank Offered Rate, or LIBOR ,is a benchmark interest applied to funds borrowed between financial instutions in the London interbank lending market.
Is LIBOR Similar To The Federal Funds Rate?
Yes, but only a little. In the American financial system, the Federal Funds Rate is used as a guideline for the unsecured lending that occurs on the U.S. interbank market. LIBOR does perform this same function for banks in the United Kingdom, acting as the benchmark interest rate between English banks, but LIBOR differs because of the method used to calculate it, the number of financial instruments to which it serves as a guide, and the body that manages it.
How Is LIBOR Calculated?
LIBOR is officially defined as “the rate at which an individual contributor panel bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to 11:00 London time.”
The rate is calculated based on a survey of banks operating in London’s financial sector (the number or banks surveyed depends on the product in question) conducted on behalf of the British Bankers’ Association. The highest four and lowest four responses are discarded and then an average is taken of the remaining ten. This rate is calculated every day, just prior to 11a.m London time, and reported thirty minutes later. Because LIBOR is used as a guide for different types of instruments, loan types, etc, a LIBOR rate is reported for each of these.
Maturities Available For LIBOR:
- 1 through12 months
- 2 weeks
- 1 week
- 24 hours
To What Financial instruments Does LIBOR Apply?
There are three classes of financial instrument that LIBOR is used for: Standard Interbank Products, Commercial Field Products, and Hybrid Products.
Standard Interbank Products:
- Forward Rate Agreements
- Interest Rate Futures
- Interest Rate Swaps
- Overnight Indexed Swaps
- Different types of Interest Rate Options Contracts
Commercial Field Products:
- Floating Rate Notes
- Floating Rate Certificates of Deposit
- Syndicated Loans
- Variable Rate Mortgages
- Term Loans
- Range Accrual Notes
- Step Up Callable Notes
- Target Redemption Notes
- Hybrid Perpetual Notes
- Collateralized Mortgage Obligations (CMO’s)
- Collaterilized Debt Obligations (CDO’s)
LIBOR is also used to fix exchage rates for the world’s major currencies
- Australian Dollar
- Canadian Dollar
- Swiss Francs
- Danish Krone
- British Pound Sterling
- Japanese Yen
- New Zealand Dollar
- Swedish Krona
- U.S. Dollars
What Body Administers LIBOR?
LIBOR was created and is managed by the British Bankers Association, a banking and financial services industry trade association in the United Kingdom. This is an important distinction to make between LIBOR and FFR. The Federal Funds Rate is a target set and monitored by the Federal Reserve Board, which is an agency of the U.S Government. As a trade association, the BBA is legally defined as, “A membership organizaton of persons engaging in a similar or related line of commerce”.The BBA consists of 253 member banks, with headquarters in 50 countries and operations in 180 nations worldwide. Legally it can’t conduct business operations that would produce profit for itself or any of its members but its members can voluntarily contribute funds to it.
Do LIBOR Averages Bear Weight In U.S. Financial Markets?
LIBOR averages do have wide-reaching implications for the American financial system. LIBOR is used to fix exchange rates for the U.S. Dollar, and four major U.S. banks are on the 18 member panel that computes the Dollar LIBOR average. Data from the Federal Reserve Bank of Cleveland indicates that in 2008, approximately 60 percent of prime-ajustable rate mortgages and almost all subprime mortgages were indexed to the U.S. Dollar LIBOR. Today nearly 45 percent of prime, and better than 80 percent of subprime mortgages are indexed to that same average.
Can The LIBOR Be Trusted?
In 2008, an article published by The Wall Street Journal titled “Study Casts Doubt On Key Rate”, highlighted an independent study that showed inconsistencies between reported borrowing costs for LIBOR. This underreporting would have made London’s financial system appear healthier than it actually was; lower interbank rates suggest that banks can continue to borrow unsecured funds from one another cheaply. At first it was difficult for both British and American regulators to actually prove that any purposeful underreporting occurred, since LIBOR is an average collected from the opinions of a private consortium of bankers outside of any public exchange. However in July of this year the Financial Times published a piece by a former trader (firm unspecified) who confirmed that LIBOR manipulation had been a common practice since the early 1990’s, inciting a more robust investigation by American and British authorities.
At present, regulators from Britain’s Financial Services Authority are proposing a series of changes and regulations to the LIBOR averaging system.
- Intentional manipulation of rate reporting would become a criminal offense.
- Regulators may reduce the number of rates from 150 to 20 to improve the accuracy of reporting.
- New audits to ensure that traders can’t profit from small changes to LIBOR.
The regulations are promising, and should provide greater accuracy and stability for LIBOR, but more could be done to integrate the BBA paneling system into the government’s regulatory structure. This way, the process of determining the rates would be more transparent and catching fraud would be somewhat easier.
Anything Else We Should Know?
While not of American origin, LIBOR does play an important role in the American financial system. Thanks to its scope, the averages reported each day impact many of the investment products traded on American exchanges and even the exchange rate of the American dollar itself. Consumers and investors should continue to pay close attention to changes in the LIBOR model as new developments arise.Powered by Sidelines