Global banks also borrow from their fellow banks. And when they do, an interest rate, called LIBOR, is attached. The LIBOR typically affect the interest rates attached to other types of loans issued to persons, business and governments. Keep reading to learn the meaning of LIBOR and its implications.
Short for London Interbank Offered Rate, LIBOR is the interest rate at which global banks borrow short-term loans from one another. These loans are typically unsecured, meaning they require creditworthiness rather than collateral. Dating as far back as 1986, the LIBOR also serves as a benchmark to determine the interest rate for short, medium and long term loans.
It is based on the following currencies: British Pound, U.S. Dollar, the Euro, the Swiss Franc and the Japanese Yen. LIBOR serves seven different maturities vis: overnight, one week, one month, two months, three months, six months and 12 months. The implication of these five currencies and seven maturities is that a total of 35 LIBOR rates are calculated and published every business day.
The Intercontinental Exchange (ICE), the body that administers the LIBOR, surveys the leading global banks for estimates of the interest rates at which they will issue loans to fellow banks for various time-periods. Typically, the rates reported by each bank is based on their short or long term forecasts of how their economy will fare. The ICE then takes an average of each bank's rates and publishes them as the LIBOR rates.
The major banks in each country constitute the panel for determining the LIBOR rates in that country. So, for example, in the UK, there are institutions such as Barclays, Standard Chartered, HSBC, Royal Bank of Scotland, and a number of other global banks with a strong presence in the UK as contributors.
Effects of LIBOR
LIBOR determines the rate at which banks get to borrow from other banks, which in turn affects the rate at which those banks issue loans to the public. In fact, it has become the dominant benchmark for determining the interest rates for various types of loans, globally.
Specific loan types rates heavily influenced by LIBOR rates include credit card loans, personal loans, student loans, car loans and all forms of adjustable-rate mortgages where, for instance, interests on outstanding mortgage balance are always fluctuating. It is estimated that over $5 trillion of consumer loans are tied to the LIBOR. Even government bonds and loans taken by corporates also have their rates influenced by the LIBOR.
By implication, businesses that have loans tied to the LIBOR are sure to be affected by the fluctuations of the LIBOR rates.
Why LIBOR will be Replaced in 2023
Because banks largely determine their own LIBOR rate, it has been heavily manipulated in the past. In fact, several cases abound where bankers at major financial institutions worked with their counterparts to wrongly influence the LIBOR. As a result, loans based on the LIBOR benchmark attracted outrageous interest rates, as they were either forced low or high, depending on whatever the bank's aim was.
These acts attracted billions of pounds in fines by the authorities, as well as lawsuits and changes in regulations. As a result, the LIBOR system is being phased out by June 30, 2023 to be replaced by the Secured Overnight Financing Rate, (SOFR).
Notwithstanding its disadvantages, LIBOR has helped to integrate global banks for loan purposes. It also adds flexibility to a bank's interest rates in relation to persons, businesses and governments.
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