London Interbank Offered Rate (LIBOR) definition

What is the London Interbank Offered Rate (LIBOR)?

The London Interbank Offered Rate (LIBOR) was the interest rate benchmark used to calculate the average rate at which banks would offer a short-term loan to each other. LIBOR is currently being phased out of the international monetary system, and it will be replaced by a number of different rates for different global locations.

However, this won’t fully happen until 2021, so it is still an important term to understand. During the height of its use, LIBOR was used as a measure of the health of the entire global financial system – as a higher interbank borrowing cost implies low confidence in a bank’s ability to repay the loan.

The LIBOR rate is calculated daily, by surveying different banks around the world and averaging the findings to set the day-to-day interbank borrowing rate.

A brief history of LIBOR

LIBOR was created as a uniform measure of interest rates across different banks. It became necessary during the rapid expansion of the interest rate market in the 1980s.

The British Bankers’ Association (BBA) set up BBA settlement rates for interest levels in 1984, before these were developed into the BBA LIBOR in 1986.

LIBOR was used for many years and was the benchmark interbank lending rate. However, this all changed when LIBOR was the subject of a scandal in which it was revealed that banks had been falsely increasing or decreasing their interest rates to affect the average. This was an attempt to profit from trades, as well as to give the impression that a bank appeared more creditworthy than it was.

Investigators found that LIBOR had been the subject of unfair manipulation since at least 1991. The uncovering of the scandal was the reason that the BBA handed over responsibility for maintaining the rate to the ICE in February 2014, at which point BBA LIBOR changed to Intercontinental Exchange (ICE) LIBOR.

As a result of the LIBOR scandal, it was agreed that the rate would be phased out and replaced by a series of alternate interest rates to determine the borrowing cost between banks.

What are the pros and cons of LIBOR?

Pros of LIBOR

LIBOR is calculated in five different currencies – the US dollar, euro, British pound, Japanese yen and Swiss franc – and seven different lengths of loan. That means that there are actually 35 different LIBOR numbers posted each day, resulting in a theoretically more stable system than a global interbank borrowing rate that is underpinned by one single currency.

Cons of LIBOR

LIBOR is based on the results of a survey completed by banks rather than transaction data, making it an easy rate to manipulate – a fact which led to its eventual decline.

LIBOR replacements

There are a number of replacements to LIBOR, so that the international monetary system is not dependent on one overall rate to determine the interbank interest rates around the globe. However, phasing LIBOR out is not an overnight process, as the rate underpins around $350 trillion worth of financial derivates and loans across the global financial sector.

Many global banks and financial regulators have already started to encourage lenders to not use LIBOR in anticipation of the rate being phased out.

The alternate rates which are currently being or have already been introduced as replacements for LIBOR in other regions of the world are SONIA for the UK, SOFR for the US, ESTR for Europe, TONAR for Japan and SARON for Switzerland.