Libor, How It's Calculated, and Its Impact on You
Role in the 2012 Scandal and 2008 Financial Crisis
Libor is the benchmark interest rate that banks charge each other for overnight, one-month, three-month, six-month, and one-year loans. It's the benchmark for bank rates all over the world. Libor is an acronym for London Interbank Offered Rate. Reuters publishes it each day at 11 a.m. in five currencies. They are the Swiss franc, the euro, the pound sterling the Japanese yen, and the U.S. dollar.
On August 4, 2014, the ICE Benchmark Administration took over administration of Libor from the British Bankers Association. ICE is an acronym for Intercontinental Exchange. ICE calculates the rates based on submissions from individual contributor banks. There is also an oversight panel of anywhere from 11 to 18 contributor banks for each currency calculated.
How It's Calculated
Before ICE took over, the British Bankers' Association administered Libor. It calculated the rate from a panel of banks representing countries in each of the quoted currencies. BBA asked the banks what rate they would charge for a given currency and a given length of time.
Why It's Important
In addition to setting rates for interbank loans, Libor is also used to guide banks in setting rates for adjustable-rate loans. These include interest-only mortgages and credit card debt. Lenders add a point or two to create a profit.
Banks created Libor in the 1980s. They needed a reliable source to set interest rates for derivatives. In 1986, the first Libor rate was announced. It was in three currencies: the U.S. dollar, the British sterling, and the Japanese yen.
How It Affects You
If you have an adjustable-rate loan, your rate will reset based on the Libor rate. As a result, if Libor rises, so will your monthly payments. The same will happen to your outstanding monthly credit card debt.
Even if you have a fixed-rate loan and pay off your credit cards each month, a rising Libor will affect you. It makes all loans more expensive. This reduces consumer demand and slows economic growth. Companies that can't expand won't need to hire. As demand falls, they may even need to lay off workers. If Libor remains high, then it could create a recession and high unemployment.
Regulators Are Phasing Out Libor
On July 26, 2017, the United Kingdom's Financial Conduct Authority announced it may phase out Libor by 2021. That's because banks have slowed down on their lending to each other. That means there aren't enough transactions in some currencies to provide a good estimate of the Libor rate.
The Bank of England is evaluating different substitutes. One alternative is the Sterling Overnight Index Average. It uses banks' overnight funding rates in sterling currency. Another is the euro lending rate. The U.K. Authority would slowly phase any replacement.
In the United States, the Alternative Reference Rates Committee agreed to use a substitute for dollar rates. It will phase in the new rate in 2019. The new rate will be based on that used by repurchase agreements. These "repo" trades are themselves based on Treasurys.
2012 Libor Scandal
In 2012, Barclays bank was accused of falsely reporting lower rates than they were being offered during the period 2005 to 2009. As a result, Barclays was fined $450 million. Its CEO, Bob Diamond, resigned. Diamond said that most other banks were doing the same thing and that the Bank of England knew about it. A London court acquitted six bankers in January 2016. Three bankers were found guilty in 2015: Tom Hayes in August, and Anthony Allen and Anthony Conti of Rabobank in November.
Why would Barclays or any bank lie about its Libor rate? A bank could make higher profits by doing so. Most banks see a low Libor rate as a mark that the bank is sounder than one with a higher Libor rate. Since Barclays submitted a lower rate, you might have benefited, too. A lower Libor rate translates to a lower interest rate on many adjustable-rate loans.
How It Contributed to the 2008 Financial Crisis
But when the subprime mortgages began to default, insurance companies like the American International Group Inc. didn't have enough cash to honor the swaps. The Federal Reserve had to bail out AIG. Otherwise, all those who held swaps would have gone bankrupt.
Libor is usually a few tenths of a point above the fed funds rate. In April 2008, the three-month Libor rose to 2.9 percent even as the Federal Reserve dropped its rate to 2 percent. Banks panicked when the Fed bailed out Bear Stearns. It was going bankrupt from its investments in subprime mortgages.
Through the summer of 2008, banks wouldn't lend to each other. They feared they would inherit each others' subprime mortgages as collateral. Libor rose steadily, reflecting the higher cost of borrowing. In October, the Fed dropped the fed funds rate to 1.5 percent, but Libor rose to a high of 4.8 percent.
In response, the Dow fell 14 percent as investors panicked. Why? A higher Libor rate is like a fear tax. At the time, the Libor rate affected $360 trillion worth of financial products. The size of the problem is mind-boggling. To try and put this into perspective, the entire global economy "only" produces $65 trillion in goods and services.
As Libor rose to a full point above the fed funds rate, it acted like an extra $3.6 trillion in interest being charged to borrowers. It contributed nothing to the economy in return. Investors worried this "fear tax" would slow economic growth. It did exactly that. Not until the $700 billion bailout helped reassure banks did Libor return to normal levels.
Despite Libor's return to normal, banks continued to hoard cash. As late as December 2008, banks were still depositing 101 billion euros in the European Central Bank. That was down from the 200 billion euro level at the height of the crisis. But it was much higher than the usual 427 million euro level. Why did they do this? They were afraid to lend to each other. No one wanted more potential subprime mortgage-backed securities as collateral. Banks were afraid their colleagues would just dump more bad debt onto their books.
That means that banks were relying on central banks for their cash needs instead of each other.
The Libor rate rose a bit in late 2011 as investors worried about sovereign debt default due to the eurozone crisis. As recently as 2012, credit was still constrained as banks used excess cash to write down ongoing mortgage foreclosures.