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Libor: The Global Interest Rate Benchmark

Who’s Varying Your Interest Rate?


Saturday, August 4, 2012

One of the most important economic concepts is that money is worth money. In other words, if you want to borrow money for a certain amount of time, you must pay a fee, called “interest,” for the use of that money. The amount of the interest you pay is set by the “interest rate.” For example, let’s say you borrow $1,000 for one year at a rate of 8%. The interest you owe will be 8% of $1,000, or $80. Thus, you must pay back a total of $1,080.

With some loans, such as a fixed-rated mortgage, the interest rate remains the same for the life of the loan. However, with many other types of borrowing the interest rate is adjusted from time to time. If it goes up, you pay more money. If it goes down, you pay less. This is the case, for example, with variable rate mortgages, with credit card borrowing, with student loans, and with many types of commercial loans.

Harley Hahn

In fact, throughout the world, there are, at any time, hundreds of trillions of dollars of outstanding transactions that depend on variable interest rates. Since these interest rates are extremely important to the global economy and since, from time to time, they must be adjusted, it is only fair to ask: Who is responsible for changing the rates?

As odd as it sounds, the majority of such interest rates are changed, indirectly, by an obscure London-based organization called the British Bankers’ Association (BBA). Each weekday, at 11:00 a.m. London time, the BBA issues updated values for 150 short-term interest rates. What few people realize, however, is that as important as these magic numbers are to the global economy, they are calculated from raw data that is, for the most part, simply made up, and that the whole system is based on faith. Let me explain.

To bring order to a potentially chaotic situation, economists have developed a number of “benchmarks”: regularly adjusted interest rates that are used as international standards. For example, the interest rate for your credit card might be set at the value of a particular benchmark plus an extra 20%. If, on the day the rate is changed, the benchmark happens to have a value of, say, 3.5%, the new interest rate would be set to 23.5%. If the benchmark were 4.1%, your interest rate would be 24.1%.

The most widely used benchmarks are updated regularly to reflect the continual ebb and flow of money around the world. Although there are many such benchmarks, the seven most important (in alphabetical order) are:

  • Euro Overnight Index Average (Eonia)
  • Euro Interbank Offered Rate (Euribor)
  • Euro Overnight Index Average (Eonia)
  • Euro Interbank Offered Rate (Euribor)
  • London Interbank Offered Rate (Libor)
  • Mutan rate
  • Swiss Average Rate Overnight (Saron)
  • Sterling Overnight Index Average (Sonia)

The most important benchmark is Libor (pronounced “lye-bor”), an acronym for “London Interbank Offered Rate”. (The name will make sense in a moment.) By general agreement, Libor is used as the basis for a huge number of transactions, making it the most widely used interest rate benchmark in the world.

I have already mentioned that Libor interest rates can influence your life if you have a mortgage, a credit card, student loan, or a commercial loan. However, there are a great many other financial contracts that use floating interest rates that also depend on Libor: Specifically, many of the complex transactions called “derivatives,” which are used by professional traders. (Derivatives are financial securities that depend on other, simpler securities. For example, stock options are derivatives because they depend on the underlying stocks.)

Many of the derivatives that depend on Libor are used by companies and by governments to transfer risk from one investor to another. The most important of these derivatives are interest rate swaps, futures contracts, and option contracts.

Interest rate swaps” enable investors to protect themselves against large, unexpected changes in interest rates by exchanging one type of interest payment for another.

Futures contracts” enable producers and consumers to remove uncertainty by locking in future prices.

Option contracts” offer the right to buy or sell something for a particular price during a specified time period. They are used by investors to hedge their bets, and by speculators to make bets.

Although these derivatives may seem esoteric, they are crucial to the operation of our modern economic system. And what they all have in common with the more pedestrian consumer loans we discussed earlier is that many of them are tied to Libor. In this way, Libor stretches its tentacles into virtually all aspects of the global economy, well beyond the pockets of consumers like you and me.

As I mentioned, Libor is calculated each weekday by the British Bankers’ Association (BBA). Every morning, employees of a company contracted to the BBA question representatives who represent a number of very large banks. This daily survey provides the raw material necessary to estimate how interest rates are shaping up for the day. To gather this information, each of the bank representatives is asked the following question:

At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11:00 a.m.?”

In plain English this means:

As an official representative of your bank, we want to know your opinion. If today at 11:00 a.m. (London time), you wanted to borrow money from another very large bank, how much interest do you think you would have to pay?”

(Now you can understand the name Libor: It is an acronym for “London Interbank Offered Rate”.)

The response to the question above is a specific interest rate. Once all the numbers are received, they are sorted, from highest to lowest, and divided into four parts. The top part and the bottom part are discarded (to keep the more extreme values from affecting the result). The remaining numbers are then averaged to calculate the official Libor interest rate. This number is then reported by the BBA at 11:30 a.m. (London time).

As an example, say that the representatives of 16 different banks are asked the official question above. The top four and bottom four interest rates are discarded. The official Libor interest rate is then calculated as the average of the remaining eight numbers.

The explanation I just gave you describes how a single interest rate is calculated. However, as I told you earlier, Libor as actually a family of 150 different interest rates. This is because the BBA gathers data for 10 different currencies and for 15 different maturities. (In this sense, “maturity” refers to the length of time the money is to be borrowed.)

Specifically, the BBA uses multiple panels of bank representatives to provide information for the following 10 currencies:

  • Australian dollar (AUD)
  • Canadian dollar (CAD)
  • Swiss franc (CHF)
  • Danish krone (DKK)
  • Euro (EUR)
  • British pound sterling (GBP)
  • Japanese yen (JPY)
  • New Zealand dollar (NZD)
  • Swedish krona (SEK)
  • U.S. dollar (USD)

For each currency, the BBA gathers data for the following 15 different maturities. (In the world of economics, all of these intervals are considered “short term.”)

In this way, the BBA comes up with 150 Libor interest rates, every weekday, 15 for each of the 10 different currencies.

To keep the numbers uniform, all interest rates are expressed as yearly (per annum) rates, regardless of the time period. For example, as I write this, the current overnight (one-day) Libor rate for U.S. dollars is 0.16650%.

Let’s say that a large bank needs to borrow $1,000,000 overnight. They would pay only one day’s interest, which means the rate would be (0.16650/365)% = 0.00045616%. Multiply this by $1,000,000 to get the total interest: $456.16. Thus, the bank that borrows the money has to pay back (the next day) a total of $1,000,456.16.

Most of the time, however, Libor is not used by large banks to calculate interest on money they borrow from one another. Indeed, large banks don’t actually borrow much money from one another; the numbers they give to the BBA are, for the most part, hypothetical guesses.

Far more often, Libor is used as a base level from which other interest rates are calculated. For instance, in the United States, a typical interest rate for an adjustable rate mortgage might be specified as, say, 2.1%, plus the current six-month Libor rate. And indeed (as I write this), the current U.S. dollar six-month Libor rate is 0.73%, while the average U.S. adjustable rate mortgage is priced at 2.69%.

In this way, Libor acts as a benchmark for a vast number of other interest rates around the world. From day to day, as the 150 different Libor rates fluctuate, the interest rates that depend on them move in lockstep.

Why should this be the case? Why doesn’t everyone simply negotiate their own personal interest rates?

There are three reasons. First, it is a basic tenet of economics that human beings do not like uncertainty. Whenever we borrow, loan, or speculate, we prefer to have a reasonable amount of uniformity and fairness. If not, we feel uncomfortable. And when enough people feel uncomfortable, they become too scared to borrow, loan, or speculate, which, in turn, slows down the wheels of commerce significantly.

Avoiding such fears requires a well-defined way to set interest rates, a system that feels uniform and fair. When we use a widely accepted objective measure, such as Libor, to modify interest rates we create a feeling of certainly.

As with all of life, what feels stable is, in reality, constantly changing. In this case, it is well known that each of the 150 different Libor interest rates varies daily. Nevertheless, because the system is well-defined and transparent and because, as a general rule, the actual numbers rarely change more than a tiny bit from one day to the next, borrowers, lenders, and traders tend to feel good about basing their interest rates on Libor.

Second, most people who depend on Libor – including the professional traders who buy and sell complex derivatives – don’t actually pay attention to the details. Indeed, to almost everyone, the current value of interest rates is nothing more than an ever-changing fact of life, like the time of day or the weather or the phase of the moon: something to be noticed only occasionally, when it happens to intrude upon our lives. And when it does affect us, we simply accept what we are told is the going rate. That’s how the system works.

Finally, it is a human trait – in fact, one of the more admirable human traits – that when we can’t understand or control what is happening, we can at least look for a way to feel good about it. With respect to Libor, we tell ourselves that it is created by experts: bankers and economists who, presumably, know what they are doing.

Such beliefs are soothing, because they create the feeling that somewhere there are intelligent, skillful people who actually do understand the economy and who can, at least partially, control what is happening. Moreover, as long as we trust that our experts are acting responsibly, it takes only a mere leap of faith to see them as capable stewards, manipulating and cajoling our monetary system to work as well as it possibly can.

But is that really enough? Should we demand more than the assurance that the Libor system is well organized and that it works because people believe it works? Surprisingly, the answer is no, as we can see by looking at what happened during what we might call The Great Libor Scandal.

On May 29, 2008, the Wall Street Journal published an article that alleged that five major banks had been attempting to influence the U.S. dollar Libor rates by willfully and dishonestly submitting lower borrowing costs to the British Bankers’ Association (which, as you remember, is the organization that creates the daily interest rates).

At first, the charges were denied, both by the banks and by various regulatory agencies. However, in the fullness of time, it was found that, not only were the Journal‘s charges true, the attempted manipulation was broader and longer lasting than anyone had imagined. Indeed, on June 27, 2012, one of the British banks (Barclays) was fined a total of $450 million U.S. dollars by three different regulatory agencies.

Nevertheless, in spite of the scandal and in spite of even more complex allegations, the system is still working effectively.

That a number of very large banks attempted to manipulate the Libor system is not in dispute. Nor is there any doubt that these banks committed a serious crime against our economic system.

The crime, however, was not one of stealing or deception. (In fact, it is not yet known whether or not anyone actually lost a significant amount of money.) The problem was that, the banks, by playing fast and loose with the truth, threatened to undermine the economic faith the world has in Libor and other interest rate benchmarks.

Actually, Libor is far from being a perfect benchmark. One reason is that consumer and commercial interest rates have little connection with how much large banks might charge one another for short-term loans.

A second reason is that the numbers submitted each morning by the various bank representatives do not really indicate anything important about the economy. In fact, as I mentioned above, the bank representatives make up most the numbers, which are actually hypothetical guesses.

Finally, mathematically speaking, the method used to calculate the Libor numbers is far too simplistic to be statistically meaningful.

And yet – none of this really matters.

Why? Because the Libor interest rate benchmark, like much of our economic system, relies much more on appearance and faith than most of us are willing to admit.

The truth is, the most serious economic problems are not caused by some part of the system malfunctioning temporarily. The problems that cause the most suffering and create the most damage are those that occur when people lose faith in the system. And, so far, with all its shortcomings, Libor still commands our faith.

In other words: It works because it works.

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