Introduction to LIBOR

Explain the origins of LIBOR and how it is calculated

For decades, the key rate benchmark was the US dollar prime rate, defined “the rate at which a bank lends to favoured customers”. But this was ill-defined, inconsistent across banks, and not usable across multiple currencies. As Western economies grew in size and complexity and interest-rate derivatives markets evolved, a better interest-rate benchmark in a full range of currencies was badly needed. In the mid-1980s, the British Bankers Association (BBA) in conjunction with the major banks developed LIBOR – the London Interbank Offered Rate.

To calculate LIBOR, the BBA asked a panel of banks every day at 11am London time to submit the rates they could borrow in the interbank market in reasonable size in different maturities in a range of currencies. The highest and lowest 25% of rates submitted were discounted, and those left were averaged to arrive at LIBOR.

The interbank cash market was largely undifferentiated. Panel banks could broadly borrow at the same rates and the market largely ignored credit risk, especially in the short dates for which LIBOR was calculated. Market-derived benchmarks such as LIBOR tended to follow central bank base rates closely so were an effective transmission mechanism for policy rates into the real economy.

What happened to destabilise LIBOR during the global financial crisis?

But during the global financial crisis of 2008 as banking went into a crisis, trust between banks evaporated. Strong banks pulled back completely or only lent to other strong banks. Credit spreads for weaker banks ballooned and weaker banks worried about how it would look if they reported that their borrowing costs had spiked.

Further, the US dollar LIBOR panel was comprised mostly of non-US banks, which were finding it harder to borrow dollars in stressed market conditions. Floating rates should have been falling in line with the deteriorating economic conditions not rising because of stressed conditions in the interbank market.

Banks became unsure as to what rates to submit. Guidance from Central Banks and other regulators – on what “reasonable size” means, what banks should submit on days when the market is in chaos and trading comes to a halt – was far from clear and sometimes contradictory. It was unclear if regulators pressured banks to set their LIBOR rates artificially low to allay the crisis conditions, but it is understandable that regulators may have been tempted to suggest this given they are tasked with controlling systemic risk and defusing market panic.