What LIBOR Means To You

By Stephen Padget on April 20, 2012

Just about everyone whom has every watched TV, listened to the radio, or read newspapers and magazines has heard of it, but few really understand what it means. It is one of the most important and influential prices in finance for the entire world. Not only that, but nearly everyone is affected by it through mortgages, personal loans, and even pensions. The LIBOR, London inter-bank offered rate, is one of the most essential pieces of the world of finance but recently it appears that more than just traditional calculations are pushing the LIBOR to artificial levels creating far reaching effects all over the globe.

For a finance rate that is so imperative to world and personal finance, the creation of the LIBOR is well, stupid. As stated previously the LIBOR is the London inter-bank offered rate, which is essentially the rate at which banks lend among themselves. The rate and volume at which banks lend to each other daily means that the LIBOR must also be published every day by the British Bankers Association (BBA). The problem however, is that hard economic data to estimate this rate is not readily available as most data takes weeks or months to accurately calculate. To get around this the BBA simply asks banks what they think the lending rate should be. Yes, I said that right. The BBA simply asks banks what they would like to pay to lend to each other. Thankfully the Association does have some measures put in place to rule out completely ridiculous submissions from banks. Up to 20 banks are asked to submit estimations for each LIBOR and the top and bottom 25% are automatically thrown out before the submissions are averaged to rule out erroneous submissions. At this point the submissions of all of the banks are also published making it unlikely that any one bank would like to stand out from the group. This simple system sets arguably the most important financial rate in the world every day.

It does not take long to discover what could possibly go wrong with this system. Yes, the top and bottom 25% rule out whacky submissions and no one bank would want to be too far from the group, but what happens when enough banks to be 26% of the total bank submissions puts in artificially low rates? All of the sudden the “true” rate is slightly lowered. Essentially if a big enough group of banks and financial leaders decided to work together to lower the rate nothing would prevent them from doing so. This is exactly what is being alleged happened starting back in 2008. As the great recession began investors and bankers alike realized that risk was on the rise and rates began to increase to represent that risk. The LIBOR however, remained steady, leading many economists to question how exactly this happened. Although it took time to discover hard evidence, there are currently several class-action lawsuits in the United States, most notably the city of Baltimore, against these banks for allegedly pushing down the LIBOR’s.

Well what does this mean to readers? The most direct way it influences the average American is actually through their local towns and cities. In order for local governments to undergo costly projects, such as road construction, they must borrow large amounts of money. The most cost effective way to finance these projects is through what are called floating rates. Floating rates are exactly what they sound like. They are inherently more risky than fixed rate loans because the rate in the future is unknown. The rate “floats” based primarily on the LIBOR. This inherent uncertainty means floating rates are typically lower than fix rates, which makes them more appealing to cash strapped cities. In order to decrease their overall risk on their loans cities sometimes buy an interest-rate swap from a willing bank or group of investors. The bank or group takes on the floating rate loan and the city pays a fixed rate to them. You may be asking why a bank or group of investors would want to do this if the LIBOR based floating rate is inherently risky because of uncertainty? This is where the problem with an artificially low LIBOR comes in. If banks and groups of investors are able to artificially lower the LIBOR then the gap between the fixed rate loan value that the city is paying the bank and the floating LIBOR rate the bank is paying to the original source of the loan increases, essentially taking millions of dollars from the city. This means that your cities, which are already having trouble with the bottom line in the present economic times, are essentially being cheated out of millions of dollars by banks and groups of investors. In 2010 alone the total estimated amount of swap agreements was between $250-500 billion according to the International Monetary Fund (IMF). This means that cities, probably in all of the 40 states that allow such swap deals, lost millions annually in these deals.

This is a significant problem that world financial leaders need to address. The consequences of an artificially lowered LIBOR are not only that cities are being taken advantage of but also the representation of risk in financial products is skewed. These are the exact types of financial practices that lead to “the Great Recession” in the first place and repeating them would end in tragedy for countries, cities, and individuals across the globe.

---

Source: The Economist, April 14th - 20th 2012