Introduction[edit] In 1984, it became apparent that an increasing number of banks were trading actively in a variety of relatively new market instruments, notably interest rate swaps, foreign currency options and forward rate agreements. While recognizing that such instruments brought more business and greater depth to the London Interbank market, bankers worried that future growth could be inhibited unless a measure of uniformity was introduced. In October 1984, the British Bankers' Association (BBA) working with other parties, such as the Bank of Englandestablished various working parties, which eventually culminated in the production of the BBA standard for interest rate swaps, or "BBAIRS" terms. Part of this standard included the fixing of BBA interest-settlement rates, the predecessor of BBA Libor. From 2 September 1985, the BBAIRS terms became standard market practice. BBA Libor fixings did not commence officially before 1 January 1986. Before that date, however, some rates were fixed for a trial period commencing in December 1984. Member banks are international in scope, with more than sixty nations represented among its 223 members and 37 associated professional firms as of 2008. Eighteen banks for example currently contribute to the fixing of US Dollar Libor. The panel contains the following member banks: [19]
Bank of America Bank of Tokyo-Mitsubishi UFJ Barclays Bank BNP Paribas Citibank NA Credit Agricole CIB Credit Suisse Deutsche Bank HSBC JP Morgan Chase Lloyds Banking Group Rabobank Royal Bank of Canada Socit Gnrale Sumitomo Mitsui Banking Corporation Europe Ltd Norinchukin Bank Royal Bank of Scotland UBS AG In the United States in 2008, around 60 percent of prime adjustable-rate mortgages and nearly all subprime mortgages were indexed to the US dollar Libor. [21][22] In 2012, around 45 percent of prime adjustable rate mortgages and more than 80 percent of subprime mortgages were indexed to the Libor. [21][23] American municipalities also borrowed around 75 percent of their money through financial products that were linked to the Libor. [5][24] In the UK, the three-month British pound Libor is used for some mortgagesespecially for those with adverse credit history. The Swiss franc Libor is also used by the Swiss National Bank as their reference rate for monetary policy. [25]
The usual reference rate for euro denominated interest rate products, however, is the Euriborcompiled by the European Banking Federation from a larger bank panel. A euro Libor does exist, but mainly, for continuity purposes in swap contracts dating back to pre-EMU times. The Libor is an estimate and is not intended in the binding contracts of a company. It is, however, specifically mentioned as a reference rate in the market standard International Swaps and Derivatives Association documentation, which are used by parties wishing to transact in over-the-counter interest rate derivatives.
Scope[edit] The Libor is widely used as a reference rate for many financial instruments in both financial markets and commercial fields. There are three major classifications of interest rate fixings instruments, including standard interbank products, commercial field products, and hybrid products which often use the Libor as their reference rate
Libor is defined as: The rate at which an individual Contributor Panel bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to 11.00 London time. This definition is amplified as follows: The rate which each bank submits must be formed from that banks perception of its cost of funds in the interbank market. Contributions must represent rates formed in London and not elsewhere. Contributions must be for the currency concerned, not the cost of producing one currency by borrowing in another currency and accessing the required currency via the foreign exchange markets. The rates must be submitted by members of staff at a bank with primary responsibility for management of a banks cash, rather than a banks derivative book. The definition of "funds" is: unsecured interbank cash or cash raised through primary issuance of interbank Certificates of Deposit. The British Bankers' Association publishes a basic guide to the BBA Libor which contains a great deal of detail as to its history and its current calculation.
Definition of 'LIBOR'
LIBOR or ICE LIBOR (previously BBA LIBOR) is a benchmark rate that some of the worlds leading banks charge each other for short-term loans. It stands for IntercontinentalExchange London Interbank Offered Rate and serves as the first step to calculating interest rates on various loans throughout the world. LIBOR is administered by the ICE Benchmark Administration (IBA), and is based on five currencies: U.S. dollar (USD), Euro (EUR), pound sterling (GBP), Japanese yen (JPY) and Swiss franc (CHF), and serves seven different maturities: overnight, one week, and 1, 2, 3, 6 and 12 months. There are a total of 35 different LIBOR rates each business day. The most commonly quoted rate is the three-month U.S. dollar rate.
LIBOR (or ICE LIBOR) is the worlds most widely-used benchmark for short- term interest rates. It serves as the primary indicator for the average rate at which banks that contribute to the determination of LIBOR may obtain short- term loans in the London interbank market. Currently there are 11 to 18 contributor banks for five major currencies (US$, EUR, GBP, JPY, CHF), giving rates for seven different maturities. A total of 35 rates are posted every business day (number of currencies x number of different maturities) with the 3- month U.S. dollar rate being the most common one (usually referred to as the current LIBOR rate).
LIBOR or ICE LIBOR's primary function is to serve as the benchmark reference rate for debt instruments, including government and corporate bonds, mortgages, student loans, credit cards; as well as derivatives such as currency and interest swaps, among many other financial products.
For example, take a Swiss franc-denominated Floating-Rate Note (or floater) that pays coupons based on LIBOR plus a margin of 35 basis points (0.35%) annually. In this case, the LIBOR rate used is the one-year LIBOR plus a 35 basis point spread. Every year, the coupon rate is reset in order to match the current Swiss franc one-year LIBOR, plus the predetermined spread.
If, for instance, the one-year LIBOR is 4% at the beginning of the year, the bond will pay 4.35% of its par value at the end of the year. The spread usually increases or decreases depending on the credit worthiness of the institution issuing debt.
Another prominent trait of LIBOR or ICE LIBOR is that it helps to evaluate the current state of the worlds banking system as well as to set expectations for future central bank interest rates.
ICE LIBOR was previously known as BBA LIBOR until February 1, 2014, the date on which the ICE Benchmark Administration (IBA) took over the Administration of LIBOR. Simply, its the interest rate that banks are prepared to pay to borrow money from each other. Thats borrowing in dollars, yen, Euros, pounds for anything from three months up to a year. Heres how it works: Every day, a group of number crunchers call up 18 banks and ask them how much interest they would pay to borrow money from another bank. The crunchers toss out the four highest and lowest rates, and divide up the remaining ten to get an average. That average is published as LIBOR. The next day, they do it all again for every currency and for every maturity. LIBOR is a big deal because its used as a base rate for all kinds of other loans. Your home loan, for example, might be an adjustable rate mortgage -- and if that's the case it might be priced at three percent more than the three-month U.S. dollar LIBOR. If LIBOR falls, your interest rate goes down. If it rises, your rate goes up. So when it was revealed that LIBOR rates were manipulated, it wasn't an abstract concept -- that manipulation had a direct affect on you and me. How were those rates manipulated? It's not complicated: When the number crunchers called around every morning, some banks were lying. And because LIBOR was overseen by an insider's club called the British Bankers Association, rather than by a proper regulator, no one ever checked to see if the banks were telling the truth. Which leaves one final question: Why London? Tradition. London was the biggest banking center in the world when they started measuring LIBOR, back in 1986. Early History of LIBOR In the early 1980s, banks and hedge funds began trading more and more options based on loans. They needed a standard method to determine what a bank would charge for a loan in the future. These derivatives promised higher returns for the banks, but they were difficult to negotiate the contract until both parties agreed on what the interest rate would be. That's when the British Banking Association stepped in. In 1984, it created a panel of banks that it would poll on what interest rate they would charge for various loan lengths and various currencies. This poll would be used by all banks to price derivatives. In fact, the actual question posed was: "At what rate do you think interbank term deposits will be offered by one prime bank to another prime bank for a reasonable market size today at 11am?" On September 2, 1985, the BBA published the predecessor to LIBOR. The BBAIRS was the Interest Settlement rate. The first LIBOR rate was published in January 1986, in three currencies: the U.S. dollar, the British sterling and the Japanese Yen. Today, the LIBOR rate is given for ten currencies, in fifteen maturities ranging from overnight to 12-month loans. In addition, BBA changed the question asked of the panel of banks, in response to the realities of the financial crisis of 2008. Banks are now asked: "At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?" BBA changed the question because it is more realistic and gives better results to ask a bank what it could actually do, rather than a hypothetical question. (Source: BBA, Historical Perspective) The most famous barometer for short-term interest rates in the world, the London Inter Bank Offered Rate, or LIBOR, is the interest rate that the most credit-worthy banks around the world charge each other for loans ranging from twenty-four hours to five years. This global inter-bank market provides a means for financial institutions with excess capital to earn higher rates of return by its loaning liquid assets to those in need of the funds. LIBOR is released each day at 11 a.m. London time. It then fluctuates throughout the day based upon the markets expectations for economic activity and the future direction of interest rates.
How Is LIBOR Used? In addition to setting rates for interbank loans, LIBOR is also used to guide banks in setting rates for adjustable-rate loans, including interest- only mortgages andcredit card debt. Lenders typically add a point or two to create a profit. The BBA estimated that $10 trillion in loans are affected by the LIBOR rate. LIBOR is also the rate used to base the price for credit default swaps. These are a form of insurance against the default of loans. They helped caused the financial crisis of 2008 by lulling banks and hedge funds into thinking there was no risk to the mortgage-backed securities these swaps insured. However, when the subprime mortgages that were behind these derivativesbegan to default, insurance companies like AIG didn't have enough cash on hand to pay off all the swaps. The Federal Reserve had to bail out AIG to keep all those who held swaps from going bankrupt. Even today, LIBOR is the basis for $350 trillion of credit default swaps. LIBOR was created in the 1980s as banks called for a reliable source to set interest rates for derivatives. The first LIBOR rate was announced in 1986 for three currencies: the U.S. dollar, the British sterling and the Japanese Yen. (Source: BBA,The Basics) LIBOR Goes Haywire in 2008 LIBOR is usually a few tenths of a point above the Fed funds rate. However, in April 2008, the 3-month LIBOR rose to 2.9% even as the Federal Reserve dropped its rate to 2%. Banks panicked when the Fed bailed out Bear Stearns, which went belly-up thanks to investments in subprime mortgages. Through the summer of 2008, banks wouldn't lend to each other, fearing they would inherit each others' subprime mortgages as collateral. LIBOR rose steadily, reflecting the higher cost of borrowing. In October, the Fed dropped the Fed funds rate to 1.5%, but LIBOR rose to a high of 4.8%. In response, the Dow dropped 14% as investors panicked. Why? A higher LIBOR rate is like a fear tax. At the time, the LIBOR rate affected $360 trillion worth of financial products. The size of the problem is mind-boggling. To try and put this into perspective, the entire global economy "only" produces $65 trillion in goods and services. As LIBOR rose to a full point above the Fed funds rate, it was like an additional $3.6 trillion in interest that was being charged to borrowers, but contributing nothing in return. Investors were afraid this "fear tax" would slow economic growth -- which is exactly what it did. Not until the $700 billion bailout helped reassure banks did LIBOR return to normal levels. However, despite LIBOR's return to normal, banks continued to hoard cash. As late as December 2008, banks were still depositing 101 billion euros in the European Central Bank -- down from the 200 billion euro level at the height of the crisis. However, it was much higher than the normal 427 million euro level. Why did they do this? They were afraid to lend to each other. No one wanted more potential subprime mortgage-backed securities as collateral. Banks were afraid their colleagues would just dump more bad debt onto their books. This means that banks were relying on central banks for their cash needs, instead of each other. The LIBOR rate rose a bit in late 2011, as investors worried about sovereign debtdefault due to the eurozone crisis. As late as 2012, credit is still constrained as banks use excess cash to write down ongoing mortgage foreclosures. For more detail about the actual LIBOR rates, see Historical LIBOR Rates.
How It Affects You If you have an adjustable-rate loan, your rate will reset based on the LIBOR rate. As a result, if LIBOR rises, so will your monthly payments. The same will happen to your outstanding monthly credit card debt. Even if you have a fixed-rate loan and pay off your credit cards each month, a rising LIBOR will make all types of consumer and business loans more expensive. This reduced liquidity will cut back on consumer demand, slowing economic growth. Businesses that can't expand won't need to hire. As demand falls, they may even need to lay off workers. If LIBOR remains high, then it could create a recession and resultant high unemployment. Article updated September 10, 2014
Fixed rates in USD[edit] There are four money markets in the world having interbank offered rate fixings in USD, including: Libor fixed in London Mibor, or MIBOR (Mumbai Interbank Offered Rate) fixed in India Sibor, or SIBOR (Singapore Interbank Offered Rate) fixed in Singapore Hibor, or HIBOR (Hong Kong Interbank Offered Rate) fixed in Hong Kong The USD Libor in London is the most recognised and predominant one. The USD Sibor was established in January 1988, and the USD Hibor was launched in December 2006. Although these fixings in USD use similar methodology by fixing at 11:00 am at their local times, the results of the three fixings are different. Interest rate swaps[edit] Interest rate swaps based on short Libor rates currently trade on the interbank market for maturities up to 50 years. In the swap market a "five year Libor" rate refers to the 5 year swap rate where the floating leg of the swap references 3 or 6 month Libor (this can be expressed more precisely as for example "5 year rate vs 6 month Libor"). "Libor + x basis points", when talking about a bond, means that the bond's cash flows have to be discounted on the swaps' zero-coupon yield curve shifted by x basis points in order to equal the bond's actual market price. The day count convention for Libor rates in interest rate swaps is Actual/360, except for the GBP currency for which it is Actual/365 (fixed).
LIBOR and Eurodollars LIBOR loans are expressed in Eurodollars; United States currency held by foreign entities, such as a British or German bank or insurance company. Eurodollars are most often the result of American companies using U.S. dollars to pay internationally-domiciled corporations for goods, service, and merchandise purchased. When Uncle Sam is running a trade deficit that is, purchasing more goods from abroad than it sells the natural result is an increase in Eurodollars; the result is more foreigners purchasing American companies and assets. What Are the Historical LIBOR Interest Rates The table below shows a snapshot of the historical LIBOR rates compared to the Fed funds rate for each year (as of December 31) since 1986. Pay particular attention to the LIBOR rates during 2006-2009, when it is compared to each change in the Fed Funds rate. It shows how LIBOR diverged slightly in the fall of 2007, and then really diverged in the spring of 2008. It returned to more normal levels by the end of 2009 in response to Federal Reserve measures to restore liquidity . From 2010 - 2013, the Fed kept interest rates low with quantitative easing by buying U.S. Treasury notes and mortgage-backed securities. In the summer of 2011, the Fed announced Operation Twist, another form of quantitative easing. Despite this easing, the LIBOR rate rose in late 2011 as investors grew concerned about potential debt defaults from Greece and other contributors to the eurozone debt crisis.
Why LIBOR is Important LIBOR is important because it is often used as the base for variable-rate government and corporate loans and derivative-based products such as credit swaps. A small, impoverished nation, for example, may have to pay a spread of a percentage point or two above and beyond the established LIBOR rate; thus, an increase or decrease in LIBOR will result in a corresponding rise or fall in its cost of borrowing.
Libor now has a new administrator but our reforms have gone much further When the Libor scandal broke just before I became chief executive of the British Bankers Association (BBA), the banking industry was condemned by politicians, the media, and in pubs and homes across the country. For many, it encapsulated what was wrong with the industry both at an individual and institutional level. It seemed the banks were morally bankrupt. This week marked an important step in clearing up that mess, regaining public trust, and changing the industry for good. We announced that we will transfer responsibility for the administration of Libor from the BBA to NYSE Euronext. The appointment of a new administrator a London-based, UK registered company, regulated by the UKs Financial Conduct Authority was one of the key recommendations of the Wheatley Review, set up in the wake of the scandal to restore credibility to the index. It makes no sense for the industrys trade association funded by the banks to oversee a rate to which so much of the banks business is pegged. Only by making the administrator completely independent can we rehabilitate Libor. This has been my top priority since taking over at the BBA. But far from initiating the reform process, the transfer to the new administrator is but the latest step in a programme to fundamentally overhaul Libor by implementing the Wheatley recommendations. For example, we have simplified the rate to make sure it is more robustly based on underlying transactions and so more difficult to abuse. Last year, there were 150 different Libor rates 15 maturities for each of ten currencies. However, the few underlying trades in some rates could in theory make those rates easier to manipulate. From the end of this month, only five currencies and seven maturities will be quoted every day (35 rates), making it more likely that the rates submitted are underpinned by real trades. The Danish, Swedish, Canadian, Australian and New Zealand Libor rates have been successfully terminated, without disruption to the financial markets. Since the beginning of July, each individual submission that comes in from the banks is embargoed for three months. As Libor should be reflective of the rate at which contributor banks can borrow funds, embargoing individual submissions reduces the motivation to submit a false rate to portray a flattering picture of creditworthiness. Knowingly or deliberately making false or misleading statements in relation to benchmark-setting was made a criminal offence last year. A new code of conduct, introduced by a new interim oversight committee, builds on this by outlining the systems and controls firms need to have in place around Libor. For example, each bank must now have a named person responsible for Libor, accountable if there is any wrongdoing. The banks must keep records so that they can be audited by the regulators if necessary. The administration of Libor has itself become a regulated activity, meaning the BBA has had to overhaul its own operations. With the Libor scandal, the reputation of the banking industry reached its nadir. Now, Libor is being completely reformed. Recent years have already seen the most wide-reaching regulatory change to any industry, and more is on its way. The new administrator for Libor is an essential step in the rehabilitation of banking. ABOUT BBA LIBOR BBA LIBOR Ltd began a consultation in November 2012 on how initial changes would be implemented. A phased discontinuation of certain LIBOR currencies and maturities were proposed. The streamlining of LIBOR tenors and currencies during the early months of 2013 resulted in the number of rates published daily, reducing from 150 to 35. The Hogg Committee was set up in February 2013 to independently oversee a tender process to recommend a new administrator for LIBOR. The BBA worked with the Committee during the tender process and BBA LIBOR Ltd became regulated as the interim administrator of LIBOR on 2nd April 2013. From 1st July 2013, the BBA implemented Wheatleys recommendation to embargo the rates submitted by individual panel banks for 3 months. On 9th July 2013, the BBA board voted unanimously to approve the transfer of the administration of LIBOR to the bidder recommended by the Hogg Tendering Advisory Committee. BBA LIBOR Ltd has engaged constructively with the new administrator to ensure a smooth transition. The BBA LIBOR published Code of Conduct included formal adoption of the Wheatleys guidelines for the LIBOR submission process. On 12th July 2013, Issue 1 of the Interim Code of Conduct for Contributing Banks was confirmed as Industry Guidance by the FCA. The new administrator will take over a benchmark with better regulatory oversight and improved governance. While the BBA is not directly involved in the process, the Bank of England is sponsoring and supporting work which aims to improve benchmark design and administration. Professor Daryll Duffie of Stanford University is leading this work
Reliability and scandal[edit] Main article: Libor scandal On Thursday, 29 May 2008, The Wall Street Journal (WSJ) released a controversial study suggesting that banks might have understated borrowing costs they reported for Libor during the 2008 credit crunch. [33] Such underreporting could have created an impression that banks could borrow from other banks more cheaply than they could in reality. It could also have made the banking system or specific contributing bank appear healthier than it was during the 2008 credit crunch. For example, the study found that rates at which one major bank (Citigroup) "said it could borrow dollars for three months were about 0.87 percentage point lower than the rate calculated using default-insurance data." In September 2008, a former member of the Bank of England's Monetary Policy Committee,Willem Buiter, described Libor as "the rate at which banks don't lend to each other", and called for its replacement. [34] The former Governor of the Bank of England, Mervyn King later used the same description before the Treasury Select Committee. [35][36]
To further bring this case to light, The Wall Street Journal reported in March 2011 that regulators were focusing on Bank of America Corp., Citigroup Inc. and UBS AG. [37] Making a case would be very difficult because determining the Libor rate does not occur on an open exchange. According to people familiar with the situation, subpoenas have been issued to the three banks. In response to the study released by the WSJ, the British Bankers' Association announced that Libor continues to be reliable even in times of financial crisis. According to the British Bankers' Association, other proxies for financial health, such as the default-credit-insurance market, are not necessarily more sound than Libor at times of financial crisis, though they are more widely used in Latin America, especially the Ecuadorian and Bolivian markets. Additionally, some other authorities contradicted the Wall Street Journal article. In its March 2008 Quarterly Review, The Bank for International Settlements has stated that "available data do not support the hypothesis that contributor banks manipulated their quotes to profit from positions based on fixings." [38] Further, in October 2008 the International Monetary Fund published its regular Global Financial Stability Review which also found that "Although the integrity of the U.S. dollar Libor-fixing process has been questioned by some market participants and the financial press, it appears that U.S. dollar Libor remains an accurate measure of a typical creditworthy banks marginal cost of unsecured U.S. dollar term funding." [39]
On 27 July 2012, the Financial Times published an article by a former trader which stated that Libor manipulation had been common since at least 1991. [40] Further reports on this have since come from the BBC [41][42] and Reuters. [43] On 28 November 2012, the Finance Committee of the Bundestag held a hearing to learn more about the issue. [44]
In late September 2012, Barclays was fined 290m because of its attempts to manipulate the Libor, and other banks are under investigation of having acted similarly. Wheatley has now called for the British Bankers' Association to lose its power to determine Libor and for the FSA to be able to impose criminal sanctions as well as other changes in a ten-point overhaul plan. [45][46][47]
The British Bankers Association said on 25 September that it would transfer oversight of LIBOR to UK regulators, as proposed by Financial Services Authority Managing DirectorMartin Wheatley and CEO-designate of the new Financial Conduct Authority. [10]
On 28 September, Wheatley's independent review was published, recommending that an independent organization with government and regulator representation, called the Tender Committee, manage the process of setting LIBOR under a new external oversight process for transparency and accountability. Banks that make submissions to LIBOR would be required to base them on actual inter-bank deposit market transactions and keep records of their transactions supporting those submissions. The review also recommended that individual banks' LIBOR submissions be published, but only after three months, to reduce the risk that they would be used as a measure of the submitting banks' creditworthiness. The review left open the possibility that regulators might compel additional banks to participate in submissions if an insufficient number do voluntarily. The review recommended criminal sanctions specifically for manipulation of benchmark interest rates such as the LIBOR, saying that existing criminal regulations for manipulation of financial instruments were inadequate. [11] LIBOR rates may be higher and more volatile after implementation of these reforms, so financial institution customers may experience higher and more volatile borrowing and hedging costs. [12] The UK government agreed to accept all of the Wheatley Review's recommendations and press for legislation implementing them. [13]
Bloomberg LP CEO Dan Doctoroff told the European Parliament that Bloomberg LP could develop an alternative index called the Bloomberg Interbank Offered Rate that would use data from transactions such as market-based quotes for credit default swap transactions and corporate bonds.
Criminal investigations[edit] On 28 February 2012, it was revealed that the U.S. Department of Justice was conducting a criminal investigation into Libor abuse. [50] Among the abuses being investigated were the possibility that traders were in direct communication with bankers before the rates were set, thus allowing them an advantage in predicting that day's fixing. Libor underpins approximately $350 trillion in derivatives. One trader's messages indicated that for each basis point (0.01%) that Libor was moved, those involved could net "about a couple of million dollars". [51]
On 27 June 2012, Barclays Bank was fined $200m by the Commodity Futures Trading Commission, [7] $160m by the United States Department of Justice [8] and 59.5m by theFinancial Services Authority [9] for attempted manipulation of the Libor and Euribor rates. [52] The United States Department of Justice and Barclays officially agreed that "the manipulation of the submissions affected the fixed rates on some occasions". [53][54] On 2 July 2012,Marcus Agius, chairman of Barclays, resigned from the position following the interest rate rigging scandal. [55] Bob Diamond, the chief executive officer of Barclays, resigned on 3 July 2012. Marcus Agius will fill his post until a replacement is found. [56][57] Jerry del Missier, Chief Operating Officer of Barclays, also resigned, as a casualty of the scandal. Del Missier subsequently admitted that he had instructed his subordinates to submit falsified LIBORs to the British Bankers Association. [58]
By 4 July 2012 the breadth of the scandal was evident and became the topic of analysis on news and financial programs that attempted to explain the importance of the scandal. [59] On 6 July, it was announced that the U.K. Serious Fraud Office had also opened a criminal investigation into the attempted manipulation of interest rates. [60]
On 4 October 2012, Republican U.S. Senators Chuck Grassley and Mark Kirk announced that they were investigating Treasury Secretary Tim Geithner for complicity with the rate manipulation scandal. They accused Geithner of knowledge of the rate-fixing, and inaction which contributed to litigation that "threatens to clog our courts with multi-billion dollar class action lawsuits" alleging that the manipulated rates harmed state, municipal and local governments. The senators said that an American-based interest rate index is a better alternative which they would take steps towards creating.