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What Is Libor – London Interbank Offered Rate History & Scandal

By Christy Rakoczy

canary wharfRecently, the term Libor – short for London Interbank Offered Rate – has been brought to the foreground of world news, with a scandal unfolding through an admission of fraudulent banking practices by one of the United Kingdom’s most popular banking institutions. On June 27, 2012, Barclays Bank was fined $200 million by the Commodity Futures Trading Commission, $160 million by the United States Department of Justice, and £59.5 million by the Financial Services Authority for alleged manipulation of the Libor rate.

The stir-up may have some people wondering: What exactly is Libor?

The Inception of Libor

The existence (and importance) of Libor began more than 30 years ago, when banks realized they needed a consistent benchmark by which to calculate prices for bank-to-bank services in the 1980s. Until then, a barter system was in place which resulted in haggling between banks on numerous types of loans.

The new system, which measures the average estimate of interest rates proposed by participating banks, was able not only to reign in financial uncertainty, but also act as a barometer for the nation’s financial health in general.

The first publication of the Libor rate occurred on New Year’s Day in 1986, although, at the time, its scope and influence were much smaller. Today, it is one of the most highly relied-upon financial standards in the world. It influences interest rates charged between banks on loans, and determines the interest rate on a range of financial instruments, including bonds, savings accounts, derivatives, mortgages, and student loans. In this way, it ultimately affects what interest rates are available to consumers as well.

How Is Libor Decided?

The British Bankers’ Association (BBA) is the primary trade association involved in the financial welfare of the UK. More than 200 banks are listed as members of the BBA, and they reach across 60 individual countries. It is the responsibility of the BBA not only to regulate the financial affairs of the UK, but also to set Libor.

Libor is set by collecting rates reported by the world’s most successful and financially stable banks. Each day, major banks including Bank of America, Barclays, JPMorgan, Deutsche Bank, and HSBC submit the estimated interbank interest rate they believe to be financially viable based on the economic climate in their location. The BBA discards the lowest and highest numbers and compresses that number into an average that becomes the Libor rate.

Libor is posted at 11am London time each day. Although it may fluctuate, the rate is fixed for the 24-hour period following its publication. While banks do not necessarily have to lend money to each other at this designated rate, there are more than $350 trillion in financial products and derivatives that are directly tied to the Libor rate.

Is Libor Relevant Only to London?

Although London is featured in the title, Libor’s reach and relevancy extend far beyond London. The term comes simply from the fact that London is where Libor is decided and posted.

The more than 200 banks that use the Libor system are spread all across the globe throughout the United Kingdom, New Zealand, Australia, and Europe, among other major locations. Trillions of dollars in worldwide loans (both business and personal) are tied to Libor publications, as investments in everything from mutual funds to mortgage rates to stock futures depend on that number.

Although most American banks use another metric called the Prime Rate when setting interest rates, the Libor rate is also used by many American companies to determine whether sending their money overseas would be more lucrative than keeping it in American banks. Even the average American can be affected by Libor as sometimes people with adjustable rate mortgages or debt will have their loan rate tied to the Libor index (for example, your mortgage interest rate might be Libor+2, which would mean your rate is two points above the Libor rate).

There is no question that this association of financers is of great consequence to anyone with an eye on the world’s financial health and future.

libor

Libor Scandal

In late June 2012, a multinational bank by the name of Barclays, based in the United Kingdom, admitted to intentional efforts to manipulate the Libor rate based on private interest.

When banks are financially confident, the estimated interest rate they report to the BBA is lower, as there is no anticipation of economic downturn, and a low interest rate is financially viable. When there is economic turmoil, the estimated interest rate reported will be higher and loaning to other banks is suddenly more of a risk.

But the Barclays Bank scandal has spotlighted the possibility that other banks may also have been reporting based on conditions that don’t exist, such as reporting lower-than-acceptable interest rates to lower the price of borrowing. Not only that, but investors whose rates are tied to the Libor index would also receive lower interest rates than market conditions warrant on the basis of the manipulation occurring.

There is evidence that this manipulation of Libor has been in practice for years, and that individual divisions of some large financial institutions have been working in collusion to manipulate their numbers, based on what would be most profitable for both parties in the short term.

The danger of corruption in the Libor system is, as with so many financial scandals, that it eventually results in a loss on the consumer’s end. In addition to losses sustained by consumers receiving artificially low interest rates, banks turning too low a profit can slowly leach funds out of popular investments – investments which, in turn, fund local governments and public services.

Final Word

It is unclear what changes, if any, the Libor scandal will cause to the way the BBA conducts business, and even more unclear is whether the perpetrators of the scandal will be held accountable for their actions. Barclays in particular has been levied a fine of $450 million, but according to NPR, there are multi-national layers of probable wrongdoing that will take intense investigation to uncover.

As the Libor scandal unfolds and questions come into play about the reliability of the Libor system, investors and individuals who lost money as a result of Libor may continue to suffer the effects of the fraud. Those who profited – including individuals with artificially low mortgage rates and student loan rates – will, of course, not have to return their profits, while those who lost money as a result of  the manipulation may file suit against the fraudulent banks to try to recoup their losses. Without a return of the profits, but with an obligation to pay for the losses, these banks may not be able to meet their liabilities.

Recent financial events have shown what happens when banks are in danger of collapse, taking entire economies with them. Potentially, if Barclays and other participating banks are not afforded protections, another bailout could be on the horizon.

(photo credit: Bigstock)

Christy Rakoczy
Christy Rakoczy earned her undergraduate degree from the University of Rochester and her Juris Doctorate from UCLA School of Law. She is currently a full-time writer who writes both textbooks and web content related to personal finance and the law. She and her husband and two dogs split their time between Florida and Pennsylvania.

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