Libor, also known as ICE Libor, is the interest rate at which banks offer to lend wholesale money to other banks in the international interbank market. Libor stands for London Interbank Offered Rate.
It is an important yardstick rate that reflects how much it costs banks to borrow funds from each other.
Apart from helping decide the price of several types of transactions, it is also used as a measure of trust in the financial system. It reflects the confidence the financial institutions have in each other’s financial health.
Although it appears to refer just to what goes on in London, it is, in fact, the reference rate for approximately $450 trillion of financial products globally, ranging from savings accounts, mortgages, credit cards, corporate loans and interest rate swaps.
Libor has a major impact on global finance
Any change in Libor has a major impact on virtually every financial transaction or agreement that takes place globally.
Tiny daily fluctuations in the Libor rate can decide whether derivatives traders (traders in Futures contracts, forward contracts, options and swaps, etc.) make or lose money.
People paying off mortgages, credit card debts, or personal loans are more likely to be affected if there is a concerted effort to push Libor up or down for a sustained period.
There are several rates banks can quote when lending or borrowing money from each other, such as Libid (London interbank bid rate) or Limean (London interbank mean rate). However, Libor is by far the most commonly quoted.
The rate is fixed on a daily basis by the major banks. However, as banks agree on transactions involving huge funds (for example, in Eurodollars), this will change.
How is Libor set?
There is a system in which banks lend money to one another. On a daily basis, a group of major banks submits the interest at which they will lend to other financial institutions.
These major banks suggest rates in five major currencies, covering fifteen different loan periods, ranging from 12 months to overnight. The five major currencies are the American dollar, British pound sterling, European euro , Japanese yen and Swiss franc.
The 3-month dollar Libor is considered the most important rate. It is an estimate of what banks would pay other banks to borrow dollars for a 3-month period if they borrowed the money on the day the rate was being set. An average is then calculated.
Imagine four major banks (called W, X, Y & Z) submit their rates. Bank W submits at 1%, X at 2%, Y at 3% and Z at 4%. The two quartiles at the top and bottom (1% and 4%) are discarded, and an average is calculated of the remainder (2% and 3%). The average of 2% and 3% is 2.5% (this is Libor).
It used to be known as BBA Libor (for British Bankers’ Association Libor or the trademark bbalibor), until the responsibility for the administration was transferred to the Intercontinental Exchange.
According to the ICE Benchmark Administration (IBA), an independent subsidiary of Intercontinental Exchange, every contributor bank is asked to base its ICE Libor submissions on the following question:
“At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am London time?”
Video – What is Libor?