How LIBOR Interest Rates Are Set
How Your Mortgage Rate May Depend on Bankers in London
Oct 11, 2008
LIBOR is an acronym for London InterBank Offered Rate, and is a benchmark published by the British Bankers' Association that reflects the interest rates at which banks offer to lend unsecured loans to each other in the London money market.
Why LIBOR Was Created
After a trial period, the BBA LIBOR fixings officially started on 1 January 1986. Although based in London, BBA membership covers some 200 banks from 60 countries. London is host to over 500 banks from around the world, with over 20% of all international bank lending and over 30% of foreign exchange transactions taking place through the offices of banks in London. The LIBOR rates were created as the financial industry started to use increasingly sophisticated instruments, such as interest rate swaps, and the BBA felt that some measure of standardisation was necessary to ensure the smooth functioning of the London and global markets.
How the Daily LIBOR is Fixed
Each of the 10 currencies for which rates are published has a BBA LIBOR Contributor Panel of between 8 to 16 banks. These banks submit their lending rates for a number of different expiry dates. The submissions are independent and there is no period of negotiation, such as happens at the London Gold Fix. Once all the banks have submitted their rates the BBA can calculate that day's fix. This is done by removing a quarter of the highest and lowest quotes and then calculating the mean of the remaining interest rates – known as the interquartile mean. So, for example, the Euro panel has 16 members, so the highest 4 quotes and the lowest 4 are removed and an average calculated of the remaining middle 8 values. The process for fixing the LIBOR rates starts at 11 am London time and the data released as soon as possible after this, usually at about 11:30.
LIBOR Maturity Dates
There are 15 different maturities, or lending periods, calculated for each currency and fixing day. These range from the shortest maturity, known as the overnight (O/N) rate, to the longest being the one-year rate. The US Dollar 6-month rate is often used to calculate US mortgages, whereas British mortgage lenders often use the Pound Sterling 3-month LIBOR rate. The rates one sees quoted are for 360 days (365 days for Pound Sterling) so to calculate the actual interest rate for, say, the one-week rate requires simply dividing the number by 360 (or 365) and then multiplying by 7.
The actual interest rates that banks use to lend either to each other or to clients is a commercial decision and may well differ from the LIBOR rate, however, the rate is used as a benchmark from which they adjust their different lending rates.
How LIBOR Relates to the Credit Crunch
As of writing, the world's financial system is deep within what has been called the credit crunch. The 10 October 2008 LIBOR 3-month US Dollar rate was 4.82% even though the US Federal Reserve target rate is just 1.5% and their Primary Credit rate is 1.75%. This means that, theoretically, a large bank can borrow from the Fed at 1.75% and then lend to other banks at nearly 5%. This is historically a very large difference and potentially good profits for the banks. However, with so many high profile bank failures banks are unwilling to lend to each other in case the borrower goes bankrupt – hence the credit crunch. On the same day, the overnight LIBOR rate dropped sharply to 2.47% and could be the beginning of some much-needed liquidity returning to the financial markets.
