As a nation that relies on credit for everything from credit cards and personal loans to student loans and mortgages, we understand the effect that interest rates have on our personal finances. When we hear of interest rates going up, we know that it means many of our long-term, big-ticket purchases will cost more. On an individual level, higher interest rates may cause less spending. On a national and global level, higher interest rates can trigger a recession.
We also know that interest rates reflect the risk that banks take from lending to consumers and to each other. But how are interest rates calculated to accurately reflect the risk that banks take? One of the common standards is done through a survey of international banks. The London Interbank Offered Rate (or LIBOR) is the benchmark standard that sets the baseline for virtually every interest rate that affects us as consumers.
In this article, we’ll review what LIBOR is, how it is calculated and why it’s significant. Other topics that this article will cover include how closely LIBOR tracks with the Federal Funds rate and why LIBOR was created.
What is the LIBOR?
The London Interbank Offered Rate is the lowest rate that banks charge to lend to each other. LIBOR is actually a series of average interest rates that are compiled by the InterContinental Exchange (ICE) based on a survey of between 11 and 18 large, international banks on the London money market. LIBOR rates are recalculated daily and published at around 11:45 EST.
The LIBOR rate is actually a series of rates that reflect seven different maturity periods from an overnight lending rate to a 12-month rate. As you might expect, the LIBOR rate is higher the longer the length to maturity. For example, as of November 2018, the overnight LIBOR rate was 2.18% while the 12-month LIBOR rate was 3.13%. In addition to the differing maturity periods, the LIBOR rate is calculated for 5 different currencies - U.S. Dollar (USD), Euro (EUR), British Pound (GBP), Japanese Yen (JPY) and Swiss Franc (CHF). This means there are a total of 35 different LIBOR rates published every day. The most commonly quoted LIBOR rate is the three-month U.S. dollar rate. You will hear this referred to as the “current LIBOR rate”.
Over the years, different currencies have been added and removed. Many foreign currencies stopped being tracked when the Euro was adopted as a common currency for participating European nations.
How is the LIBOR rate calculated?
Every morning the participating banks are required to answer the following question, “At what rate could you borrow funds were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 a.m.?” The ICE then uses a method called trimmed arithmetic mean in which the outlying (extreme) interest rates are excluded. The remaining rates are totaled and divided by the number to come up with the published average. So if they survey 15 banks and deem that four banks numbers are outliers, the LIBOR rate for that day would be based on the arithmetic average between the remaining 11 banks.
The accuracy and composition of the LIBOR rates can be subjective because it relies on bank employees to give objective answers. To that end, the ICE notes that the phrase “reasonable market size” contained within the daily question is intentionally left undefined and ambiguous.
Why is the LIBOR significant?
LIBOR is seen as the lowest interbank lending rate. It sets other interest rates which are commonly expressed as “LIBOR + x bps”. In this case, bps stands for basis points and x represents a premium that the lender charges to the borrower that is above the LIBOR rate.
LIBOR is also the common standard used for derivative instruments such as interest rate swaps and futures contracts. In this role, central banks and financial institutions can use LIBOR as a predictive tool to gauge the future direction of interest rates. A decrease in the LIBOR rate should, in theory, lead to consumers saving a few dollars on a mortgage or student loan.
As the popularity of options trading has blossomed there are at any given time trillions of dollars in outstanding contracts being held by lending institutions. The maturity dates may vary from overnight to 30 years. In fact, the UK Treasury estimates that the value of financial contracts that are tied to the LIBOR rate is up to $300 trillion. That number does not include consumer loans or adjustable rate mortgages which can be added hundreds of trillions of dollars.
As an example of how the LIBOR rates affect certain transactions consider a common interest rate swap between Company A and Company B., This is where two parties agree to exchange interest rate payments. This is typically done because one party wants to change from a fixed to a floating (or variable) rate and the other party wants the fixed rate.
Company A has a $1 million investment that pays out a variable interest rate that is equal to LIBOR + 1% each quarter.
Company B also has a $1 million investment but it pays out a fixed rate of 1.5% per quarter.
Company A’s rates are tied to LIBOR so they desire to go to a fixed rate for cost certainty. Company B is willing to accept a variable rate loan for the chance of higher interest payments. The two companies can enter into a swap agreement. Company A would receive the fixed 1.5% interest rate ($15,000) for his investment from Company B. Company B would, in turn, receive the variable interest rate of LIBOR +1% from Company A. If LIBOR is 1% then Company B would receive $20,000 (10,000 + 10,000) from Company A. Since interest rate swaps are reconciled at maturity, the net result of the swap is that Company B will receive $5,000 from Company A.
If LIBOR changes up or down in the following quarter, Company B may receive more or less from Company A or may have to pay Company A.
How does the LIBOR rate compare to the Federal Funds rate?
The Federal Funds rate is the interest rate you frequently hear referred to whenever the Federal Reserve board meets to determine the direction of interest rates. This is the interest rate that banks charge each other to lend funds they have received from the Federal Reserve to another bank in order for the receiving bank to meet the Fed’s reserve requirement.
One of the major differences between the two rates is that the Federal Funds rate is published monthly whereas the LIBOR rate is recalculated and published daily. But the larger distinction is in the intent of the two rates. In the case of the Federal Funds rate, the intention is to influence the United States' monetary policy. If the Federal Reserve feels economic activity dictates changes to the money supply or the economy's growth rate, they can raise or lower interest rates. The LIBOR rate, on the one hand, is broader in scope because it is international in focus, and narrower in scope because it is intended to be a measurement of where interest rates currently are, not where they will be. However, as noted above, the LIBOR rate is subjective and like the Federal, Reserve number can be based more on opinions than raw data.
Since its inception, the LIBOR rate has tracked very closely with the Federal Funds rate (typically the LIBOR rate has been within a few tenths of a point above the Federal Funds rate). The one exception occurred during the height of the financial crisis of 2007.
As many homeowners began to default on their subprime mortgages, financial institutions began to have liquidity concerns. One of the most notable of these was the investment bank, Bear Stearns, which was going bankrupt. Because they were an institution that was deemed “too big to fail”, Bear Stearns received a bailout from the Federal Reserve. This caused a domino effect in which banks feared lending to each other because the collateral that the loans would be based on would include subprime mortgage debt. As a result, the LIBOR rate began to climb.
At one point, in October 2008, the LIBOR rate reached 4.52% even as the Federal funds rate was down to 1.5%. It was not until the end of 2009 that the LIBOR rate started to come back into its traditional range. As of November 2018, the Federal Funds rate sat at 2.25% and the 1-month LIBOR rate was 2.34%.
Why was the LIBOR created?
In the 1980s, the practice of derivative trading (options trading) based on underlying loans became very popular. Although common practice today, at the time trading derivatives was a new concept. However, there was one problem. The value, and therefore the risk premium, of a derivative, is based on the value of an underlying security. Therefore, in the case of trading against loans, investors required a mechanism to establish the interest rate that a bank would charge for loans to be issued in the future.
The solution came in 1984 when the British Banking Association created a panel of banks that they would survey to determine the interest rate that the banks would charge for various loan lengths in different currencies. The banks were asked to answer the following question, “At what rate do you think interbank term deposits will be offered by one prime bank to another prime bank for a reasonable market size today at 11 a.m.?”
In September of the following year, the BBA published the British Bankers Association Interest Rate Swap (BBAIRS). This was the predecessor to LIBOR. In January 1986, the first LIBOR rates were posted for the U.S. Dollar, the British sterling, and the Japanese yen.
The methodology for determining the LIBOR rate remained unchanged until the financial crisis of 2008. As concerns about liquidity became paramount, the BBA saw a need to change the question
The LIBOR survey question remained unchanged until the financial crisis of 2008. In response to the crisis, the BBA modified the question to read, “At what rate could you borrow funds were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 a.m.?” This reflected the rightful concerns about liquidity in financial institutions and changed the emphasis to what the banks actually could do as opposed to what they thought they could do.
In 2014, the administration of the LIBOR rate was transferred to the InterContinental Exchange in the wake of a rate-fixing inquiry in which the BBA was found guilty of price fixing.
The bottom line on LIBOR
The LIBOR rate has become a benchmark for banks and other financial institutions in setting interest rates for a variety of financial products including savings accounts, mortgages and all kinds of loans. While certainly not the only metric that is used for determining interest rates, it is considered an important first step.
The LIBOR rate is calculated based on a survey conducted between a group of international banks. The one-question survey is used to determine a daily interest rate for 7 maturity periods and 5 currencies. The 35 LIBOR rates are published every day at approximately 11:45 EST.
As the global economy has become more complex and trillions of dollars are held by lending institutions (particularly in derivative instruments such as interest rate swaps and futures contracts), the LIBOR rate was created to provide a way for banks to establish a baseline for projecting future interest rates. While the accuracy of the LIBOR rate relies on the objectivity of the bankers who answer the survey, the methodology of the survey is designed to remove outlying data to give an accurate reflection of current interest rates.
Although the LIBOR rate has historically been closely linked to the Federal Funds rate, when it rises and falls, it can have an effect on the overall economy. During the financial crisis of 2008, the LIBOR diverged from the Federal Funds rate making it harder for banks to lend to each other. This resulted in a significant change in U.S. monetary policy that still has ramifications today.