What is the interbank rate?
The London interbank offered rate, more commonly known as Libor, is one of the most important numbers in the financial world. But until the Barclays scandal, it received scant public attention. Here is a primer.
Q. What is Libor?
A. Libor is the average interest rate at which banks can borrow from each other. London is mentioned in its name because the benchmark is set in that city.
Essentially, Libor is one of the main rates used to determine the borrowing costs for trillions of dollars in loans. Interest rates on some mortgages, student loans, and credit card accounts go up or down when Libor moves.
Q. Why was Libor created, and by whom?
A. In the early 1980s, banks started looking for a standard benchmark to calculate the prices on an array of financial products, and the British Bankers Association, an industry trade group, began publishing Libor on Jan. 1, 1986.
The idea was that instead of constantly haggling over the interest rates that would be charged for different types of loans, banks would have a uniform benchmark. There are actually 150 Libor rates published every day.
Q. How is Libor calculated?
A. For US-dollar-denominated Libor, more than a dozen banks — including Citigroup, JPMorgan Chase, Bank of America, Barclays, UBS of Switzerland, and others — estimate how much interest they would pay to borrow money on a short-term basis from other institutions. While the process is still overseen by the British Bankers Association, the calculations are now performed by Thomson Reuters.
Thomson Reuters discards the four highest and four lowest submissions as outliers, and averages the remaining ones.
Q. What are examples of how Libor is used?
A. Banks often ask borrowers to pay Libor plus an added amount of interest, reflecting the credit risk of the borrower.
Many US mortgage lenders rely on Libor to determine the interest rates they charge for adjustable-rate mortgages. Typically, an adjustable-rate mortgage might be 2 to 3 percentage points over the six-month Libor rate.
Q. Why is Libor important?
A. After more than two decades, Libor still remains one of the most-cited benchmarks in the financial world.
The British Bankers Association has promoted the rate-setting process as highly transparent and impartial, making Libor a good benchmark for various financial products. The group has argued that no one institution can single-handedly alter the calculations behind the rate.
Q. Is Libor changing as a result of the rate manipulation scandal?
A. It’s unclear. After regulators unveiled their settlement with Barclays, the association said it was ‘‘shocked’’ by the revelations and was reviewing all aspects of the Libor-setting process.