What is the London Interbank Offer Rate?

LIBOR is the acronym or short form of London Interbank Offer Rate. This refers to the international reference rate for unsecured borrowing over a short period in the interbank market. It serves as a standard for interest rates that are short-termed. It is used to price currency rate swaps, interest rate swaps, and mortgages. It functions to check how the financial system is faring health-wise and also gives an idea of the trajectory of the imminent central bank policy rates.

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How Does LIBOR Work?

When talking about the syndicated loan market, pricing of credits is at LIBOR + rates. The rate is determined by the borrowers risk in the sense that the high the borrowers risk, the higher the rate. For example, a lower risk AAA borrower might pay LIBOR + 50 basis points while a high-risk BBB borrower would pay LIBOR + 250 basis points. The Intercontinental Exchange (ICE) administers the London Interbank Offer Rate (LIBOR) and its computed for 5 different currencies, having 7 various maturity level spanning from overnight to one year. The five currencies for which it is computed include the euro, Swiss franc, Japanese yen, pound sterling, and the U.S. dollar. The Intercontinental Exchange benchmark administration comprises between 11 and 18 banks which contribute to each currency. The London interbank bid rate (Libid) is quoted by the bank intending to borrow funds or take deposits from a different bank while the London interbank mean rate (Limean) refers to the average of both of them. Apart from helping in the decision of other transactions, it is also utilized as a trust measure in the financial system. Furthermore, it shows how confident banks are in the financial health of one another. This is the reason for its importance. There is a system that is followed by banks when lending money. This implies that they do not lend money to each other anytime they please. Each day, a set of leading banks submit the interest rate at which they would lend other finance houses. They recommend rates in ten currencies covering fifteen various loan periods, spanning from overnight to twelve months. The 3-month dollar LIBOR is the most important rate. Whatever rates submitted are exactly what the banks know they will pay other banks when borrowing dollars for 3 months provided they borrowed money on the exact day the rate was set. After this, an average is calculated. This is an easy illustration of how it works. A major review of Libor, as well as, its setting were commissioned by the government after the allegations became known. Libor oversight was passed from the British Bankers Association to the Intercontinental Exchange (ICE). At the moment, rates are based on real transactions for which records are kept. Another major change is the fact that certain criminal penalties now exist for manipulating benchmark interest rates.