LIBOR, or the London Inter-Bank Offered Rate, is a key benchmark interest rate at which major global banks lend unsecured, short-term loans to one another. It is based on five currencies: the US dollar, the euro, the British pound, the Japanese Yen and the Swiss franc; and over seven different maturity periods: overnight, one week, one, two, three, six and twelve months.
The combination of these currencies and maturity periods gives us 35 distinct LIBOR rates, calculated and reported every day; however, most commonly, LIBOR refers to the 3 month inter-bank interest rate.
The Intercontinental Exchange (ICE) is responsible for calculating and publishing the LIBOR rate. They ask major global banks how they would charge other commercial banks for letting out short term loans, then they eliminate the highest and lowest values and calculate the trimmed average of the remaining figures. This is not a static rate, it changes every day, a fact which will be very significant in understanding why the LIBOR is considered one of the most important interest rates even though few people know about it.
The LIBOR rate is one of the most significant numbers globally, and despite its nomenclature, it is not restricted to London or the UK. It essentially represents the lowest borrowing rate, and banks, financial institutions, and other corporations set their interest rates over and above the LIBOR rate (LIBOR + X basis points). According to the UK Treasury, the value of financial contracts tied to LIBOR, excluding consumer loans and other mortgages, touches $300 trillion. The rate provides a fair idea to central banks about expectations on interest rates and linked developments, and it is consequently used as the floating rate for interest rate swaps, futures contracts, mortgages, student loans, corporate funding, and related transactions.
LIBOR changes every day, and this change is symbolic of fear in the interbank market. If commercial banks are fearful of an increase in the risk of default, they will be reluctant to lend and will try to push the LIBOR rate as high as they can. This will have a dampening impact on the entire market for credit since it would also drive up lending rates to individuals and institutional borrowers, as well as derivatives and futures markets.
Another important interest rate is the Overnight Indexed Swaps (OIS) rate. It is an instrument that allows financial institutions to swap their interest obligations, without having to refinance their loans or renegotiating their loan contracts. There are many overnight index rates, denominated in different currencies, but essentially it is the average interest rate that a bank or financial institution can secure for borrowing funds overnight in a certain currency. Individually, the OIS rate does not signify much, but when it is compared with LIBOR to make up the LIBOR/OIS spread, it becomes a key measure of credit risk in the banking sector, an indicator which could have warned people of impending financial doom in 2007, had they paid enough attention to it.
LIBOR is essentially the three-month borrowing rate, and OIS is the overnight borrowing rate; undoubtedly, there must be a difference between these two figures, which under normal circumstances is negligible. But there are times when there is a gap between the two which is noticeable enough, and which represents fear stocking in the market for loanable funds. As the gap between LIBOR and OIS widens, banks are more reluctant to lend out for longer periods of time, which means that they fear the risk of default. Banks would rather lend for the shortest period of time, that is, overnight than for longer periods. This pessimistic attitude signifies that not all is right within the banking sector, and the importance of the spread as an indicator of credit risk is evident by the fact that the spread between the two rates, which was about 0.01 percentage points prior to the subprime mortgage crisis, jumped to a gigantic 3.65% at the peak of the crisis.
Heedless to say that a rate as important as LIBOR cannot sustain without causing controversy. And the scandal associated involved not just one individual or one corporation, but a group of sixteen of the world’s most influential banks, at a time when the global economy was still recovering from the after-effects of the 2008 crisis. Starting from the period of economic upswing prior to the 2008 crisis, Barclays was suspected to be manipulating and misreporting LIBOR rates to suit the needs of traders and investors. Swap traders would often bribe officials who submitted the rates to quote figures that would benefit their interests and not the actual rate, and employees at Barclays even colluded with other banks to alter their rates as well. The LIBOR was “maneuvered both upwards and downwards, based entirely on the trader’s position”.
After the collapse of Lehman Brothers, when the American economy was paralyzed into a sudden downturn, a trader Tom Hayes, working for the Swiss bank UBS, engaged his contacts in the British Bankers’ Association to quote LIBOR several basis points below its actual rate.
One might ask how this small skew would affect the banking sector. No bank wants to show itself to be unstable or risky in a credit-starved environment. And quoting LIBOR lower than actual would portray that the bank does not find it difficult to borrow money from others, thus providing it a degree of stability in a highly unstable time.
For people paying mortgages at a floating interest rate, lower LIBOR would mean lower interest payments on loans, which is a good proposition for them. But, big commercial organizations which had fixed their rates on a higher LIBOR would now get lower interest payments and suffer losses, which is a huge cause for concern. LIBOR is tied to $300 trillion dollars worth of loans worldwide, and losses accruing on this amount will undoubtedly leave a sore patch on all commercial companies who suffered due to the manipulations of the “big” banks.
The most important issue, however, is that of trust. The unfolding of the LIBOR scandal could not have been at a worse time, and it only highlighted the complacency of regulatory authorities, and their continued inability to detect a fraudulent and risky phenomenon under their watch. And the drama revolving the rate eventually led all the regulatory authorities to declare the LIBOR to be phased out by the year 2021 and be replaced by an alternative that can be better kept in check by the central banks and other regulators. The search for suitable alternatives is underway, with the top contenders being SOFR (Secured Overnight Financial Rate), SONIAR (Sterling Overnight Index Average Rate) among others. But the major concern still is whether the regulatory authorities will look beyond their imaginary utopian environment and actually monitor the activities of major banks and financial institutions in maintaining the integrity of the financial sector.