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We are the World: We are LIBOR
An Overview of LIBOR and its significance
January 19, 2009
LIBOR. The BBC posits that it is “the most important number in the world.” As it is the creation of the broadcaster’s geographic and alphabetic neighbor, the BBA or British Bankers’ Association, a certain bias could be expected. But another number supports the claim for LIBOR’s primacy: $360 trillion. That is the value of the worldwide financial products whose rates are based on LIBOR, from mortgages, car loans and student loans to complex instruments such as interest rate swaps and futures contracts. Some additional perspective: the United States’ 2007 GDP was approximately $14 trillion, an amount equivalent to less than five percent of all things LIBOR.
LIBOR stands for London Interbank Offered Rate. It is the average interest rate banks are charging for unsecured loans to each other in the Interbank market varying by maturities—overnight LIBOR, one-month LIBOR, three-month LIBOR, six-month LIBOR, one-year LIBOR. In conjunction with Reuters, the BBA announces LIBOR rates daily during the 11 am hour, a British timekeeping tradition to rival the chiming of Big Ben. “Contributor banks” submit estimates on their cost of funds. LIBOR rates, calculated for different maturities and currencies, are a filtered mean of those estimates.
LIBOR is an index of individual institutions’ interbank lending rates. It is not a universal rate governing all such loans. However as a numeric summary of interbank activity, LIBOR establishes a benchmark for the global financial market. There is no more foundational transaction than interbank lending. Borrowing institutions access capital to maintain required reserves, preserving their ability to fund further loans and investments. Lending institutions carefully gauge the risk of these loans, making the resultant interest rates a barometer of confidence as fellow banks are considered “best customers.” Like with any other type of loan, the higher the rate, the higher the perceived risk. In turn, a lower LIBOR means a lower cost of funds, a lower perceived risk, and a more assured marketplace.
The BBA promotes LIBOR’s importance with the following facts:
- A long established history, dating to 1986
- Providing the broadest spectrum of international rates, calculated for a basket of the world’s dominant currencies
- A truly international reference rate, as BBA member banks hail from 60 different countries
- Wide commercial use, as the previously stated $360 trillion figure attests
- Wide international dissemination, made possible by the BBA’s partnership with
- Reuters, the participation of subscriber media, and global markets’ monitoring of the LIBOR benchmark
- A transparent mechanism, as the methods of determining LIBOR rates and the sources for data are well-known
- A robust settlement rate, signifying ease for borrowers and lenders to transact lending agreements due to numerous large and credible participants providing daily data to the BBA allowing accurate, timely, and fluid LIBOR calculations.
- Representative banks that are considered the most active in cash markets and as having the highest credit ratings
LIBOR is a daily glimpse into the London Interbank Market, revealing much from this seemingly insular world:
- The cost of borrowing money for the rest of us as we see the “rock bottom” rate banks themselves are paying. For example, monthly payments on a “LIBOR mortgage” comprise a predetermined margin above a designated LIBOR rate.
- The confidence level of influential banks based on the above. If banks are charging the proverbial arm-and-a-leg to other banks, they are sensing a riskier marketplace.
- The availability of credit based on all of the above.
LIBOR may be the world’s most important number, but only if you’re buying a home, getting a new car, financing a college education, seeking capital for a business venture, working for a company seeking capital for a business venture, or building wealth. Even if you are somehow not in this “elite” group, you may be paying rent to a property owner who is covering LIBOR-based debt obligations with your monthly check. So let’s sing along: “We are the world. We are LIBOR.”