Q: Why all the fuss lately about LIBOR, and how does it affect me?
A: The revelation of LIBOR rate manipulation by some major banks has serious implications for a global banking system already under stress from the financial crisis. LIBOR directly affects nearly every borrower in the United States, even if they never have heard the term.
LIBOR is an acronym for the London Interbank Offer Rate, a benchmark index that reflects the rate at which major global banks lend U.S. dollars to each other. Several different maturities from one day to 12 months typically are quoted, with the most familiar and useful being the three-month rate.
An analogous concept in the U.S. is the Federal Funds rate, at which American banks lend excess reserves to each other.
However, the Fed Funds rate is fixed by action of the Federal Reserve in pursuit of monetary policy initiatives, while the LIBOR rate is not set by any central bank but instead (in theory) reflects the market's estimation of interbank credit risk. This is a key distinction.
Each business day in London, the British Bankers' Association receives estimates from 18 global megabanks of the rates at which they believe they could borrow U.S. dollars from other banks in unsecured transactions. After tossing out the four highest and lowest submissions, the remaining 10 are averaged and the result is reported, typically around 11:30 a.m. London time.
So what? Well, because this rate is assumed to contain information about general credit risk in the world's most liquid financial markets, it is a reference point for literally thousands of other financial transactions.
Car loans, mortgages, student loans, business bank lines, credit cards and a host of routine derivative securities are based upon the LIBOR rate.
Virtually every American comes in contact with this obscure index on a daily basis. Scratch the surface of practically any financial arrangement in which you are involved and you will likely find the LIBOR rate somewhere in the mix. According to the Commodity Futures Trading Commission, nearly $10 trillion worth of loans are tied to LIBOR, with upward of $600 trillion in derivative contracts like currency and interest rate swaps linked to the benchmark.
Which is why the recent revelations of price-fixing are so distressing.
On June 27, Barclays Bank issued the first mea culpa, agreeing to pay $450 million in fines to U.S. and U.K. regulators in recompense for gaming the rate-setting process (reporting bogus rates). But this is just the first shoe to drop, as authorities pursue allegations against other banks (likely with the cooperation of Barclays), and the U.S. Justice Department launches criminal probes involving institutions and individuals suspected of participating.
This is a huge deal, and threatens to further undermine confidence in the global financial infrastructure and the weakened institutions at its center. Serious reforms are in order and may finally be forthcoming as the investigations proceed and the depth of the scandal is exposed. Meanwhile, get used to hearing about LIBOR a lot more in the months ahead.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Christopher A. Hopkins CFA, is a vice president at Barnett & Co. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at firstname.lastname@example.org.