Definition
The London InterBank Offered Rate (LIBOR) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. It serves as the first step to calculating interest rates on various loans throughout the world. Its purpose is to serve as a reference point for debt instruments, including government and corporate bonds, mortgages, student loans and credit cards.
Phonetic
The phonetic pronunciation for “London InterBank Offered Rate (LIBOR)” is:”ˈlʌndən ˈɪntərˌbæŋk ˈɒfərd reɪt (ˈlaɪbɔːr)”
Key Takeaways
Key Takeaways about London InterBank Offered Rate (LIBOR)
- Definition of LIBOR: The London Interbank Offered Rate (LIBOR) is the average interest rate at which major global banks borrow from one another in the international interbank market for short-term loans. It serves as a globally accepted key benchmark interest rate that indicates borrowing costs between banks.
- LIBOR’s Important Role: LIBOR is commonly used as a base rate in international lending and derivatives markets. It is used as a reference rate for a large amount of financial products such as derivatives, bonds, loans, structured products, and mortgages. Therefore, its fluctuations directly impact the interest rates of many loans and financial instruments worldwide.
- LIBOR Transition: Post-scandal in 2008, LIBOR is being phased out with a planned withdrawal by the end of 2021. Alternative rates like the Secured Overnight Financing Rate (SOFR) in the US, and SONIA (Sterling Overnight Index Average) in the UK, are being considered as replacements. This transition brings significant implications for financial institutions and borrowers, urging them to prepare for a shift in the rate-setting landscape.
Importance
The London InterBank Offered Rate (LIBOR) is crucial in the financial world as it serves as a global benchmark interest rate that reflects how much it would cost banks to borrow from each other on an unsecured basis. Financial institutions, mortgage lenders, and credit card agencies around the world use LIBOR as a base rate, adding their own margin, to calculate the interest rates they charge on loans and financial products. Hence, changes in LIBOR can affect the payments for these loans significantly. Furthermore, its importance extends into derivatives contracts such as interest rate swaps, being used as a reference rate. Therefore, LIBOR plays an essential role in influencing the global finance landscape, affecting consumer lending rates and determining the returns on various financial instruments.
Explanation
The London InterBank Offered Rate (LIBOR) is a benchmark interest rate that plays a significant role in global finance. Its primary purpose is to provide a reliable reference rate that reflects the average borrowing cost at which large, globally active banks can secure unsecured short-term loans from other banks in the London interbank market. In doing so, it gives an indication of the health of the financial system, as a higher rate typically indicates reduced willingness to provide short-term credit and vice versa.Furthermore, LIBOR is widely used as a base rate in setting the interest rates of various kinds of financial products and agreements around the world. These include complex derivatives, commercial loans, residential mortgages, student loans, and credit cards. Given the enormous value of transactions referencing LIBOR, even minor changes in the rate can have significant financial implications. Hence, LIBOR is an essential touchpoint in global finance, underpinning an estimated $350 trillion in financial contracts worldwide. However, it is worth noting that LIBOR is set to be phased out by the end of 2021, with alternative reference rates being developed in different jurisdictions.
Examples
1. Adjustable-Rate Mortgages (ARMs): Some adjustable-rate mortgages use LIBOR as the benchmark for their interest rate adjustments. If LIBOR increases, the interest rate and monthly payments on an ARM can similarly increase. For example, a homeowner with an ARM based on the LIBOR rate would have noticed an increase in their monthly payments if the LIBOR went up significantly during a certain period.2. Student Loans: Some private student loans in US use LIBOR as a reference rate to set their own interest rates. For instance, a student taking out a loan might have to pay interest calculated as LIBOR plus 2%. So if the LIBOR were at 1%, the overall loan interest rate would be 3%. If LIBOR increases to 1.5%, the interest rate on the loan rises to 3.5%.3. Business Loans: Many larger businesses operate in a variety of countries and often handle multiple currencies. If a European business wanted to invest in a UK-based facility and borrowed money from a UK bank, their loan might be subject to LIBOR. The rate they’d have to pay back would be affected by changes to LIBOR, which could impact the cost of their investment and overall profitability.
Frequently Asked Questions(FAQ)
What is the London InterBank Offered Rate (LIBOR)?
The London InterBank Offered Rate, or LIBOR, is a benchmark daily interest rate set by the banks on the London interbank market. It represents the interest rate at which banks offer to lend funds to one another in the international interbank market.
How is LIBOR used?
LIBOR is used as a reference rate for a range of financial products such as derivatives, loans, bonds, and mortgages. It’s also often used as an indicator of a market’s expectation of future interest rates and the health of the banking system.
How often is LIBOR updated?
LIBOR is updated every business day at around 11 a.m. (London time) by the Intercontinental Exchange (ICE) Benchmark Administration.
Who calculates LIBOR?
The Intercontinental Exchange (ICE) Benchmark Administration is the entity that oversees the calculation and publication of the LIBOR rates.
Why are there different rates of LIBOR for different currencies?
The cost of borrowing money can vary from one currency to another due to a variety of factors including risk and demand. Hence, different rates for different currencies are designed to reflect these differences.
Is LIBOR going to be phased out?
Yes, LIBOR is expected to be phased out by the end of 2021 and will be replaced by alternative rates, such as the Sterling Overnight Index Average (SONIA) for the UK and the Secured Overnight Financing Rate (SOFR) for the US.
What is the impact of LIBOR on ordinary consumers?
Interest rates on some personal financial products such as mortgages, student loans, and credit cards can be tied to the LIBOR rate. Therefore, changes in LIBOR can directly impact the interest payments on these loans, which can, in turn, affect the overall financial management of the consumers.
How is the LIBOR rate determined?
The LIBOR rate is determined by the rates at which a selection of banks on the London interbank market are prepared to lend to one another. Panel banks submit quotes, and the average of these quotes make up the LIBOR rate.
Related Finance Terms
- Interbank Rate: This is a term related to LIBOR which signifies the rate of interest at which banks lend and borrow from each other.
- Financial Benchmark: LIBOR is often used as a benchmark to set interest rates for different financial instruments globally, making the term financial benchmark relevant.
- British Bankers’ Association (BBA): BBA was the initial body responsible for setting the LIBOR rates.
- ICE Benchmark Administration: Currently responsible for administering LIBOR, ICE Benchmark Administration took over from BBA in 2014.
- Prime Rate: Similar to LIBOR, the Prime Rate is an index used to set lending rates. It’s the interest rate given to a bank’s most creditworthy customers.
